Do TIPS Work?

Are Treasury Inflation Protected Securities (TIPS), for which the Treasury adjusts the principal based on the Consumer Price Index for all urban consumers (CPI-U), effective as an inflation hedge? In their September 2009 paper entitled "A TIPS Scorecard: Are TIPS Accomplishing What They Were Supposed to Accomplish? Can They Be Improved?", Michelle Barnes, Zvi Bodie, Robert Triest and Christina Wang evaluate the progress of the TIPS market toward providing: (1) consumers with a hedge against real interest rate risk; (2) holders of nominal bonds with a hedge against inflation risk; and, (3) everyone with a reliable indicator of expected inflation. Using inflation rate and bond yield data available since the introduction of TIPS in September 1997, they conclude that:

• TIPS provide a good real-return hedge, despite CPI measurement error and possible demographic differences among TIPS investors. TIPS indexed to CPI are as good as TIPS indexed to other inflation measures, because inflation risk is largely independent of the measure used.
• TIPS better protect long-term, buy-and-hold investors than investors who hold TIPS for less than the full maturity. Over relatively short horizons, bond price volatility overwhelms the relatively small deviations between actual and expected inflation.
• The inflation rate implied by the difference in yields between nominal Treasury and TIPS markets are neither clean measures of expected future inflation nor likely to be good predictors of future inflation (see chart below).
• A "ladder" of TIPS, with maturities linked to anticipated expenditure timeframes, would help investors in or near retirement hedge against inflation in nominal expenses over time.

The following chart, taken from the paper, shows in simplified form how the nominal Treasury yield can be broken down into a TIPS part (expected real rate plus a real rate risk premium) and an inflation compensation part (expected inflation plus an inflation risk premium). This diagram illustrates why there is no easy way to extract the expected inflation rate from the difference between nominal and TIPS yields.

In summary, TIPS work reasonably well as an inflation hedge for long-term holders, but they are not particularly useful in measuring inflation expectations.