The Superiority of Inflation-Linked Bonds for Most Investors
Earlier this year, I started a thread on the Bogleheads forum discussing how the risks facing nominal and inflation-linked bonds (e.g., TIPS and I bonds) are asymmetric and why this is important to investors. In this post, I revisit the topic and attempt to answer some frequent questions about this analysis and its implications.
With nominal bonds such as Treasury notes, their stated yield is in nominal dollars. Conversely, the yield of inflation-linked bonds, such as Treasury Inflation-Protected Securities (TIPS) is in inflation-adjusted dollars. That is, the number of dollars that inflation-linked bonds will be worth is dependent on the level of inflation between the time the bonds were purchased and the bonds mature.
When investors buy a nominal bond that they hold until it matures, they know precisely what the nominal yield of that bond will be, but they do not know what the inflation-adjusted yield of the bond will be. If inflation turns out to be higher than the yield of the nominal bond, the investors will lose buying power even though they have more dollars than they started with. This means that nominal bonds are not ideal for funding most of consumers' future spending needs.
Conversely, when investors buy an inflation-linked bond that they hold until it matures, they know precisely what the inflation-adjusted (aka 'real') yield of that bond will be, even though they do not know what the nominal yield of the bond will be.
Inflation-linked bonds are less risky for funding most consumers' future spending needs.
Let's take a look at the current yields of nominal and inflation-linked Treasuries to see why this the above statement is true. Nominal 10 year Treasury notes are currently yielding 4.12%, whereas 10 year TIPS are currently yielding 1.70% in real dollars (i.e., their nominal yield will be the inflation rate plus 1.70%). The difference between these two yields, referred to as the TIPS breakeven inflation rate, is 2.42% and is widely taken to be the bond market's rough estimate of how much inflation will be over the next 10 years. (I have grave doubts that inflation will be that low over the next 10 years, but that's a topic for another day.)
If inflation is higher than 2.42% over the next 10 years, then those who bought TIPS will have more dollars than those who bought nominal Treasuries, and vice versa.
If we assume that inflation is highly unlikely to average below 0% over a given decade, we can assume then that the best possible real returns of 10 year nominal Treasuries is their starting nominal yield of 4.12%. But there is no limit to how low the real returns of 10 year nominal Treasuries can be. With TIPS held to maturity, their real return is known with precision at the time of purchase.
Some have correctly pointed out that in a deflationary scenario (i.e., a general reduction in the prices for goods and services), nominal bonds will have higher returns than will inflation-linked bonds. This is true, but there are two reasons why it does not 'balance out' the risks that investors have with nominal and inflation-linked bonds. First, the historical risk of unexpected inflation (i.e., actual inflation being higher than the bond market expected) in terms of both frequency and magnitude has been far greater than the risk of deflation. Second, TIPS, the most common type of inflation-linked bond, offer some protection against deflation in that their value at maturity is the greater of their inflation-adjusted price or the original principal. Nominal Treasuries offer no such protection in the event of unexpectedly high inflation.
Since inflation-linked bonds are completely protected from unexpected inflation and also offer some protection against deflation, they are less risky in terms of preserving buying power than are nominal bonds. In other words, the risks that nominal and inflation-linked bonds are exposed to are asymmetric (i.e., they are not equal).
Using the current yields of nominal Treasuries and TIPS, if inflation over the next 10 years is higher than 2.42%, then nominal Treasuries will lose buying power, and the potential loss is virtually all their buying power. Conversely, TIPS would maintain their buying power. If inflation over the next 10 years is lower than 2.42%, then both nominal Treasuries and TIPS will gain buying power, though nominal Treasuries would gain more.
The situation is a bit like 'Heads, I win. Tails, we both win, but you win more.'
While inflation-linked bonds like TIPS are certainly less risky when it comes to preserving buying power than are nominal bonds, this does not mean that their inflation-adjusted yield is always positive. There have been many points in time since they were introduced in 1997 that TIPS had negative real yields. Thankfully though, 10 year TIPS currently have a positive yield of 1.70%, their highest since 2009.
Cogent investors might be asking themselves whether, in return for lower risk in terms of funding future consumption, TIPS have lower expected returns than do nominal Treasuries. That's a big topic, but since their inception in 1997, TIPS have actually had higher average returns than nominal Treasuries. Many believe this to be driven in part by TIPS being slightly less liquid than nominal Treasuries, a premium that has resulted in higher returns.
Some have been confused that TIPS funds have lost value in 2022, but this is because TIPS are still bonds. When interest rates rise as they have significantly in 2022, the value of existing bond principal goes down. Note that those who bought TIPS directly from the U.S. Treasury and are holding them to maturity will still get the real yield they were promised by the Treasury at the time of the purchase. But if they tried to sell their TIPS before they matured, they would experience the same big fluctuations in price that TIPS funds do. This does not mean that TIPS funds are bad, but they operate differently than do individual TIPS bought directly from the U.S. Treasury.
Given that TIPS have lower risk in terms of funding future consumption than do nominal Treasuries and have not had lower returns, a strong case can be made for TIPS (and potentially I bonds; see below) being the default fixed income component of retail investors' portfolios.
This post has primarily referred to TIPS, but another type of inflation-linked bond available to U.S. investors are I bonds, a type of savings bond that can only be purchased directly from the U.S. Treasury. They have some unique characteristics, which can make them preferable at times to TIPS. Those interested in I bonds can read more about them here.