Real estate investment trusts with properties that can reset their rents regularly may be a good alternative to TIPS for investors looking to hedge against inflation.
Eric Baradat/AFP via Getty ImagesInvestors in search of ways to protect their income against inflation may need to look further than they think: The market created for that purpose may not be a great choice, for either income or returns.
Treasury inflation-protected securities, or TIPS, have attracted investor cash this year as investors bet that a mix of economic reopening and U.S. government stimulus will drive prices higher in the U.S. Funds investing in TIPS have seen 25 consecutive weeks of inflows from investors since October of last year, the longest stretch since a 69-week period that ended in early 2010. They have sent nearly $18 billion into the market—or about 16% of the total assets under management of TIPS funds as of April 7, according to Refinitiv Lipper.
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The bet might seem sensible, as many on Wall Street expect an increase in inflation this year. But there are a few reasons that investors may not get what they’re looking for from the TIPS trade.
Their current yields should be a reason for caution among income investors in particular. At the moment, all TIPS maturities other than the 30-year offer negative yields. The 10-year TIPS note yields nearly minus 0.8%, the five-year note yields about minus 1.7%, and the two-year note yields minus 2.6%.
In theory, negative yields could translate into returns if inflation climbs persistently in coming years. But the trade isn’t a simple one. For it to pay off, there needs to be more inflation than the levels that are already priced into the market today. “For TIPS to work, I have to be right on inflation. That’s a pretty difficult call,” says Tom Atteberry, co-manager of the FPA New Income fund. “The Federal Reserve has a lot of smart people, and they haven’t been great at predicting inflation, either.”
Inflation is expected to be highest over the short term, but the market reflects that already. For example: For the two-year TIPS note to be more attractive than a comparable Treasury, inflation would need to average more than 2.7% over the next two years. For the five-year TIPS note to be attractive, inflation would need to run above 2.6%.
Atteberry points out that even during the rebound after the financial crisis, the calendar year with the fastest inflation was 2011, when it averaged just 3%. Over a longer period of the recovery, for 2010 through 2014, it averaged 2%.
He acknowledges that the comparison isn’t perfect. But even if this time is different, there’s another problem: When inflation rises, normal Treasuries’ yields tend to rise, too. That explains why the ICE BofA All Maturity U.S. Inflation-Linked Index has lost 1.2% so far this year: Because TIPS receive all of their inflation adjustments upon maturity, their duration is longer than other bonds with comparable maturities, so their performance is hurt more by rising yields.
“People say, ‘I got the inflation theme right, I bought TIPS, and I lost money,’ ” says Gene Tannuzzo, head of global fixed income at Columbia Threadneedle Investments. “The TIPS asset class is an imperfect hedge for inflation, and that is especially true today.”
Income Investing
There are also tax issues for investors who own TIPS outright, rather than through a fund: Investors have to pay tax on gains in the securities’ principal and coupon adjustments in real time, before they receive any of the income.
Beyond that, there are other market-structure issues that make the securities less attractive. The Fed owns about 20% of the market, for one, which may affect liquidity. And in the U.S., TIPS adjustments are made according to data that aren’t seasonally adjusted, which can add more volatility to the market.
Instead of TIPS, Tannuzzo recommends that investors buy bonds of energy companies, which could benefit from the rise in oil and gas prices that has helped boost inflation this year. Investors may also want to buy real estate investment trusts with properties that can reset their rents regularly, such as residential multifamily housing. A couple of REITs in that sector that are popular with Wall Street analysts are Essex Property Trust (ticker: ESS) and UDR (UDR).
Write to Alexandra Scaggs at alexandra.scaggs@barrons.com
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