Why TIPS Won’t Protect Against Rising Rates
Sponsored by ProShares
As of October 29, 2021, Treasury securities protected against inflation (called TIPS) have a term of 7.7 years. Duration is a measure of how sensitive a bond or bond fund is to changes in interest rates. The longer the duration of a bond, the more sensitive it will be to changes in interest rates. This means that if US Treasury rates rise 1%, the price of TIPS could drop 7.7%. You might be saying to yourself, âWait. I thought TIPS protected investors from rising interest rates, right? The short answer is “not quite”.
TIPS can help protect investors from rising inflation expectations, not inflation itself, and not specifically rising interest rates. So while our research indicates that TIPS have historically outperformed Treasuries during periods of rising interest rates, hedging interest rate risk (rather than inflation expectations) has in fact been a more direct and efficient solution.
Interest Rate Hedged Corporate Bonds Outperformed TIPS During Rising Interest Rates – Index Comparison
Source: Bloomberg, 12/31/2013 to 09/30/2021. Average performance based on quarterly changes in the 10-year Treasury yield. Rising periods are any calendar quarter in which the 10-year Treasury yield has increased. Interest rate hedged bonds are represented by the FTSE Corporate Investment-Grade (Treasury-Rate Hedged) index. âTreasury billsâ are represented by the Bloomberg US Treasury Index. TIPS are represented by the Bloomberg US TIPS Index.
Current environment could create headwinds for TIPS
Inflation expectations can certainly rise when interest rates rise, and that is why, as the chart above shows, TIPS have historically outperformed regular Treasuries when rates have risen. However, the FTSE Corporate Investment Grade (Treasury Rate-Hedged) Index performed even better as interest rates can rise even if inflation expectations do not. This is the objective of the Fed’s tapering program. The objective is to create an increase in interest rates that comes either: a) without accompanying the rise in inflation expectations; or b) with rate increases that exceed expectations of rising inflation. And that’s a recipe for disappointing TIPS performance.
Understanding TIPS also requires a brief talk about the difference between inflation expectations and current inflation. TIPS generally work well when future inflation expectations rise, not when current measures of inflation rise. TIPS have performed well so far in 2021, up around 5% through 10/29/21, as shown by the Bloomberg US TIPS Index. This means that higher inflation expectations are potentially already reflected in TIPS prices.
Break-even inflation rates are calculated by looking at the difference between the returns on TIPS compared to a nominal (or typical) Treasury at the same maturity. Equilibrium rates help provide insight into what investors expect the rate of inflation to be over a specified period of time. Let’s look at those expectations below.
Profitability expectations could face the pressure of transitory inflation
Source: Bloomberg, as of 10/29/21.
The 10-year breakeven point stood at 2.6% at the end of October, above the Fed’s 2% inflation target. If investors decide current inflation levels are likely transient, breakeven inflation expectations could drop, putting pressure on TIPS performance relative to the broader fixed income market.
Consider a bond strategy with a covered interest rate instead of tips
The current period of extremely low real interest rates and high inflation expectations may not be a good time to invest in TIPS. Going forward, the Fed probably wants real interest rates to rise and inflation to be brought under control. With interest rate risk and credit risk being the main drivers of return on bond strategies, now may be the time to shift to credit risk. Consider interest rate hedged bond strategies, which invest in portfolios of high quality or high yield bonds with built-in hedges that directly target the impact of rising Treasury rates.
One strategy for investors that focuses on quality fixed income investments includes ProShares Investment Grade â Interest Rate Hedged (IGHG).
GHG is an innovative bond ETF which:
- Offers return potential from a diversified portfolio of high quality corporate bonds.
- Has an interest rate hedge that uses Treasury forward contracts to target zero interest rate risk.
- For more information, visit ProShares.com
This information is not intended to be investment advice. There is no guarantee that the strategies discussed will be effective. Investment comparisons are provided for guidance only and are not intended to be exhaustive.
All forward-looking statements contained in this document are based on the expectations of ProShare Advisors LLC at this time. ProShare Advisors LLC assumes no obligation to update or revise forward-looking statements, whether as a result of new information, future events or otherwise.
Investment is currently subject to additional risks and uncertainties associated with COVID-19, including general economic, market and business conditions; changes in laws or regulations or other actions taken by government authorities or regulatory bodies; and global economic and political developments.
There are risks involved in investing, including the possible loss of capital. This ProShares ETF has certain risks, including risks associated with the use of derivatives (swaps, futures and similar instruments), imperfect correlation with the benchmark, leverage and price movement. market, all of which can increase volatility and reduce performance. Please see the summary and the full prospectus for a more complete description of the risks. There can be no assurance that a ProShares ETF will achieve its investment objective.
Bonds will lose value as interest rates rise.
Short positions in a security lose value as the price of that security increases.
The fund concentrates its investments in certain sectors. Closely targeted investments tend to exhibit higher volatility.
GHG does not attempt to mitigate factors other than rising Treasury interest rates that impact the price and yield of corporate bonds, such as changes in the underlying credit risk perceived by the business entity market. GHG seeks to hedge investment grade bonds against the negative impact of rising rates by taking short positions in Treasury futures. These positions lose value as Treasury prices rise. Short positions are not intended to mitigate credit risk or other factors influencing bond prices, which may have a greater impact than rising or falling interest rates. Investors may be better off in a long only investment grade investment than investing in GHG when interest rates remain unchanged or fall, as hedging may limit potential gains or increase losses. No hedge is perfect. Since duration hedging is reset on a monthly basis, interest rate risk may develop during the month and there can be no assurance that short positions will completely eliminate interest rate risk. Additionally, while GHG seeks to achieve an effective duration of zero, the hedge cannot fully accommodate changes in the shape of the Treasury’s interest rate (yield) curve. GHG may be more volatile than long-term investment grade bond investments. IGGH’s performance could be particularly poor if investment grade credit deteriorates as Treasury interest rates fall. There can be no assurance that the fund will have positive returns.
Carefully consider the investment objectives, risks, fees and expenses of ProShares before investing. This and other information can be found in their summary and in full. prospectus. Read them carefully before investing.
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