Turns Out Hawkish Jay Might Be Transitory?
We’re all very aware of inflation. Most people have felt it at least a little in their lives from gas prices, groceries, rent, staples, travel, and so on. Some investors and traders expect inflation to be persistent and uncomfortably high for a while. They might even be very bullish on the market in the medium-term but want to have at least some cash to ride out volatility for an emergency or hedge against potential large declines.
They may feel forced into a false dichotomy that either they have to see cash burn in real terms or speculate on the short-term direction of the market. Turns out there are ways to potentially protect your cash if inflation ends up being more persistent than we all think. One of those solutions is TIPS – aka Treasury Inflation-Protected Securities. Who are examples of people that might consider buying them?
- Someone looking to park cash to make a large purchase of some kind next year that can remain illiquid until that time but concerned that inflation will be very high.
- Someone bullish looking to hedge a highly growth tilted portfolio – “keeping some dry powder” on the side.
- Older investors looking to protect the value of cash expecting interest rates to rise further.
- Bearish trader speculating on a market decline but not wanting to go all-in the high risk of shorting the market either directly or with options.
How do they work?
TIPS are just like regular Treasury bonds. They have a fixed coupon rate that is applied to its face value twice a year to pay interest. The key difference however is that the face value or principal is continually updated to reflect changes in the CPI-U index (the general urban CPI index we are all familiar with on the news).
TIPS are issued and auctioned by the US Treasury in 5, 10, and 30 year terms. Since their scheduled auction and maturity dates have effectively been scattered throughout the year you will always be able to find whatever term you are looking for, and they can be purchased from your broker.
Accrued Principal
The adjusted principal or accrued principal is the most important part of a TIPS bond. The way it is calculated is by multiplying the original face value by the CPI Index Ratio also called “inflation factor”. It is equal to the current CPI divided by the CPI index when the bond was issued. Thus Index Ratio = (Reference CPI current date / Reference CPI issue date).
These index ratios can be verified and calculated just using BLS data but the Treasury also just publishes them for you. Most brokers will include all this data on their client portal or trading UI.
Here’s an example of a TIPS bond with the following ID, CUSIP – 912828UH1. It has three key dates 1) Issue date 2) Dated date 3) Maturity date. The issue and maturity is the same as a regular bond. The “Dated date” is the reference date to begin the CPI calculation, often middle of the month a couple weeks before the bond was auctioned, usually Jan 15th or Aug 15th.
For this bond, the dated date CPI is 230.82203 the CPI on January 15, 2013. The CPI today is 291.88477 the “daily reference CPI”. So the index ratio or inflation factor is 291.88477/230.82203 = 1.26454. Hence the adjusted principal for each $1000 of face value is $1,264.54.
The adjusted principal is key because that moving balance is basically what coupon rates will be applied to on coupon dates and finally whatever it has climbed to is what you receive at maturity. It is fairly straight-forward and intuitive but there is one small but very important detail to be aware of. The CPI reference is lagging behind by three months.
That means that the dated date (CPI at issue) is 1/15/2013 but in reality the CPI used is 10/15/2012. Similarly the reference daily CPI today is actually 4/27/2022 not 7/27/2022 (today)! I am not sure what the reason for this is but if I had to guess it is because of data lags that used to exist and the time needed to publish CPI. In any case, this means that if you buy TIPS today they do not yet include hot months of May, June, and anything that happened in July! Since CPI is published by month, a simple linear interpolation (straight average) is used to calculate CPI days between months.
Effective Yield
Finally, the effective yield is what you would expect on an annualized basis assuming consumer prices were completely stable going forward. It is determined the exact same way as a regular bond except the face value is the current daily accrued principal. The Wall Street Journal has a nice table of all TIPS yields (if someone knows of a better table to compare yields please let me know).
https://www.wsj.com/market-data/bonds/tips
Today yields went down quite a bit based upon what was perceived as dovish Fed guidance which one would expect to be inflationary. But if you look at the April 15 2024 TIPS, it has a yield of -.18% which is close to 0. That means that most of the gain from this bond will be from inflation. If somehow inflation were 0 from here you would basically break even.
A regular Treasury bond with a maturity of 4/15/24 has a yield of 3.034%. The difference between these two numbers can be used to calculate the break-even rate. 3.034-(-.18) = 3.214% is the market’s expected annualized rate of inflation for the next 21 months.
This is the critical number to look at when placing your bet. If you think inflation will be higher than this figure you should buy TIPS. If you think inflation will be lower you buy the normal Treasury instead.
Final Thoughts
So there you have it, this is one tool to potentially hedge a bit against inflation. Some might also like precious metals, energy / commodities, or BTC. One strong advantage of TIPS is its stability and guaranteed nature of at least keeping up with inflation. Pretty much nothing else can do this and basically the taxpayer foots the bill if inflation goes substantially higher than what regular Treasuries are pricing.
*** Note also I am not a financial advisor and this is not financial advice. Perhaps goes without saying but “Here are some TIPS* for you” is not meant to signal a recommendation!
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