As we discussed previously, one strategy to protect against higher than expected inflation is to shift some nominal bonds to inflation-linked bonds, like Treasury Inflation-Protected Securities (TIPS). But what are the risks? And how do they perform?
TIPS are subject to real interest rate risk, just like other bonds. However, since inflation-linked bonds are only responsive to changes in real interest rates (nominal bonds are also sensitive to inflation expectations), this risk is lessened. Rising interest rates generally have more influence on longer-term securities, making their valuations more volatile.
Since 2000, TIPS have outperformed nominal treasury bonds by a cumulative 15% on the all-maturity benchmark. In 2016, a considerable adjustment in inflation expectations took place, which led TIPS to outperform nominal treasuries rather significantly, particularly on the longer term.
So, what should investors consider?
Investors with the view that future inflation will be higher than currently expected should favor TIPS over nominal treasuries, and vice versa. Expectations regarding development of real interest rates affect the choice of terms. Should real interest rates rise, shorter-term bonds may be the preferable choice.
Investors should be aware that past performance is not an indicator of future results.