Many investors are asking whether the risk of inflation is currently underestimated. As we discussed previously, the market has witnessed an upward trend in US inflation since the presidential election.
As we’ve seen, one option for protecting against inflation shocks is to shift some nominal bonds to inflation-linked bonds, like Treasury Inflation-Protected Securities (TIPS). But how do TIPS behave?
Unlike nominal bonds, TIPS are protected from an unexpected rise in inflation. In 2016, TIPS had quite a strong performance relative to nominal bonds. Both nominal bonds and TIPS are influenced by changes in inflation expectations and real interest rates. The moderate rise in inflation and change in rates in 2016 largely explain the better performance of TIPS compared to nominal bonds.
If investors decide to diversify their nominal portfolios with TIPS, what’s the difference between shorter- and longer-term TIPS?
Just like nominal bonds, TIPS also carry interest rate risk, and longer-dated TIPS (with maturity greater than 10 years) carry considerable more interest rate risk than shorter-maturity TIPS. For investors who prefer to follow the realized inflation more closely, a shorter-term TIPS portfolio is the more appropriate solution.
Investors should be aware that past performance is not an indicator of future results.