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Among the many challenges advisors confronted last year were the failings of various asset classes with inflation-fighting reputations.
Gold. Real estate. Treasury Inflation-Protected Securities (TIPS). You name it and it was probably a dud in 2022 despite multi-decade readings of the Consumer Price Index (CPI). Take the case of the Schwab U.S. TIPS ETF (NYSEARCA: SCHP) – one of the largest exchange traded funds in the TIPS category.
SCHP, which follows the Bloomberg US Treasury Inflation-Linked Bond Index, has $13.6 billion in assets under management and charges just 0.04%. Couple that low fee with the Schwab branding and the fund is an advisor favorite. However, SCHP lost 12% last year, barely better than the 13% shed by the Bloomberg US Aggregate Bond Index. Worse yet, SCHP was 130 basis points more volatile than the “agg.”
Bad news: Inflation, though declining, is still high and the Federal Reserve’s 2% goal is basically a joke at this point. Good news: SCHP and friends are finally getting their respective acts together. The Schwab ETF is higher by 3% year-to-date while yielding almost 7%. Impressive stats to be sure and more could be on the way because inflation isn’t going anywhere anytime soon.
TIPS for the Long-Term
Arguably one of the failings of TIPS last year came by way of perception. These bonds were perceived to be inflation hedges (they are), but that reputation wasn’t adequately put into context.
“While TIPS can protect investors against inflation over the long run, they aren't necessarily a short-term ‘hedge,’ as recent experience has shown. Over short periods of time, price declines can offset the principal adjustment from rising inflation. That's what happened last year—yields rose so sharply that the decline in prices more than offset the surge in inflation,” notes Collin Martin of Charles Schwab.
Looked at another way, while TIPS aren’t an exotic asset class that’s difficult for clients to grasp, there’s still opportunity here for advisors to add value through psychology and explaining important fundamentals tied to these bonds.
Another area of emphasis for advisors helping clients navigate TIPS is understanding the coupon and maturity of this form of debt –issues many clients probably aren’t well-versed in.
“The coupon payments are based on a percent of the adjusted principal, so investors can benefit from higher income payments when inflation is rising, as well,” adds Martin. “At maturity, however, a TIPS investor would receive either the adjusted higher principal or the original principal value at issuance. In other words, TIPS never pay back less than their initial principal value at maturity.”
Understanding How Inflation Impacts TIPS Yields
As noted above, yields on TIPS ETFs are elevated – the product of last year’s declines. Additionally, many clients know that bond yields move inverse of prices. However, there’s an added component with TIPS many clients may not be aware. That is the “real yield,” which is designed to reflect inflation.
For advisor, this isn’t a complex topic, but the nuance of it could be confusing to clients, indicating there educational opportunities with TIPS.
“If inflation averages 3% for the next five years, for example, that 3% inflation rate would get added to the roughly 1.3% ‘real’ yield that a five-year TIPS offers today, resulting in a nominal return of 4.3% annually,” concludes Martin. “The higher (or lower) inflation comes in, the higher (or lower) that nominal total return would be. That can be an important concept for investors who are worried that inflation will remain very elevated for a while.”
Related: Lean on a Bond Giant for Retirement Planning Solutions