In search of an elusive yield

September 2016

TIPS are fixed income securities issued by the United States Treasury. The Treasury defines them as a way to “Provide protection against inflation. The principal value of a TIPS increases with inflation and decreases with deflation, as measured by the Consumer Price Index (CPI).” The CPI measures changes in prices “paid by urban consumers for a representative basket of goods and services.” Keeping pace with inflation means that as the price of goods and services increase, consumers earn enough on their investments to continue to purchase the same goods and services they previously bought. TIPS pay interest semi-annually at a rate tied to the inflation-adjusted principal. If the principal value has gone up because the inflation rate has increased, then the interest payment will go up. If a TIPS purchaser holds the security until maturity, he or she is paid either the adjusted principal or original principal value, whichever is greater, allowing the total return on the investment to either meet or exceed the rate of inflation.

TIPS versus regular Treasuries

When deciding whether to purchase TIPS, we look at the breakeven rate, also known as the inflation spread.  This is the difference between the yield of a regular Treasury securities and the real yield of a TIPS with a similar maturity.  We believe this is an indicator of expected inflation and the relative value of TIPS versus Treasuries. Historically, when the inflation spread has gotten bigger, TIPS have tended to outperform, if everything else stayed relatively the same.

Positive outlook for TIPS

To assess the potential for TIPS, we look at the historical averages, the upper and the lower band breakeven rates for 10-year TIPS over a 10-year period.  Currently the inflation breakeven rate is in the lower band in the third quarter of the year, down significantly from earlier in the year. Although there is potential downside in terms of breakeven, given data from the past year, actual inflation has ranged higher. Wages are expected to increase as the country reaches full employment. In turn, employers must pay more as the demand for employees grow versus the supply. If that occurs, the breakeven inflation rate will likely move higher, which could result in TIPS outperforming other fixed income instruments as the inflation spread increases.

Understanding TIPS

TIPS are fixed income securities issued by the United States Treasury. The Treasury defines them as a way to “Provide protection against inflation. The principal value of a TIPS increases with inflation and decreases with deflation, as measured by the Consumer Price Index (CPI).” The CPI measures changes in prices “paid by urban consumers for a representative basket of goods and services.” Keeping pace with inflation means that as the price of goods and services increase, consumers earn enough on their investments to continue to purchase the same goods and services they previously bought. TIPS pay interest semi-annually at a rate tied to the inflation-adjusted principal. If the principal value has gone up because the inflation rate has increased, then the interest payment will go up. If a TIPS purchaser holds the security until maturity, he or she is paid either the adjusted principal or original principal value, whichever is greater, allowing the total return on the investment to either meet or exceed the rate of inflation.

TIPS versus regular Treasuries

When deciding whether to purchase TIPS, we look at the breakeven rate, also known as the inflation spread.  This is the difference between the yield of a regular Treasury securities and the real yield of a TIPS with a similar maturity.  We believe this is an indicator of expected inflation and the relative value of TIPS versus Treasuries. Historically, when the inflation spread has gotten bigger, TIPS have tended to outperform, if everything else stayed relatively the same.

Positive outlook for TIPS

To assess the potential for TIPS, we look at the historical averages, the upper and the lower band breakeven rates for 10-year TIPS over a 10-year period.  Currently the inflation breakeven rate is in the lower band in the third quarter of the year, down significantly from earlier in the year. Although there is potential downside in terms of breakeven, given data from the past year, actual inflation has ranged higher. Wages are expected to increase as the country reaches full employment. In turn, employers must pay more as the demand for employees grow versus the supply. If that occurs, the breakeven inflation rate will likely move higher, which could result in TIPS outperforming other fixed income instruments as the inflation spread increases.

Steady or rising rates appear to favor TIPS

TIPS were first issued in January 1997.  Therefore, there is not a lot of historical data, which makes it difficult to conclude from an analytical viewpoint which environments are favorable to TIPS. We believe, however, there are indications that in steady or rising rate circumstances, which in our opinion represent the most likely scenario ahead for the U.S., TIPS have the potential to outperform Treasuries (Tsy) and the Barclays Aggregate (Agg). With the limited data available, declining rates, which we are not currently anticipating, were not favorable to TIPS.

In periods of severe yield swings, the only time TIPS underperformed was during the period when the Federal Reserve wound down quantitative easing in the form of bond purchases to stimulate the economy. We believe it is unlikely that such a dramatic event will take place in the near term. In fact, during the most recent dramatic fixed income market event, Brexit, TIPS outperformed.

Higher yields likely

We believe that real yields in the U.S. will continue to move higher in the near and, to some extent, medium term.  We feel, however, a constrained upside is limited due primarily to global factors. We also anticipate that inflation expectations will remain stable or move higher, as actual inflation edges higher. Therefore, we forecast that a potential rate hike will happen in December 2016.

Based on our outlook for yields and inflation, we believe that it is a favorable environment for TIPS. Our proposed allocation to TIPS reduces our short duration exposure, while continuing to be underweight duration versus the benchmark, reflecting our view of limited upside for yields. We remain mindful that even small changes in expectations or actual data could change the outlook, so we will continue to keep a close eye on yields and inflation.

Asset Management

Developing and executing an investment strategy that encompasses every aspect of your financial life

Learn More »


Contact Us

View all Wealth Management and Hawthorn Office Locations »


 

Important Legal Disclosures and Information

The material presented in this newsletter is of a general nature and does not constitute the provision by PNC of investment, legal, tax, or accounting advice to any person, or a recommendation to buy or sell any security or adopt any investment strategy. Opinions expressed herein are subject to change without notice. The information was obtained from sources deemed reliable. Such information is not guaranteed as to its accuracy. You should seek the advice of an investment professional to tailor a financial plan to your particular needs. For more information, please contact PNC at 1-888-762-6226.

The PNC Financial Services Group, Inc. (“PNC”) uses the marketing names PNC Wealth Management® and Hawthorn, PNC Family Wealth® to provide investment, wealth management, and fiduciary services through its subsidiary, PNC Bank, National Association (“PNC Bank”), which is a Member FDIC, and to provide specific fiduciary and agency services through its subsidiary, PNC Delaware Trust Company or PNC Ohio Trust Company. PNC also uses the marketing names PNC Institutional Asset Management®, PNC Retirement Solutions®, Vested Interest®, and PNC Institutional Advisory Solutions® for the various discretionary and non-discretionary institutional investment activities conducted through PNC Bank and through PNC’s subsidiary PNC Capital Advisors, LLC, a registered investment adviser (“PNC Capital Advisors”). Standalone custody, escrow, and directed trustee services; FDIC-insured banking products and services; and lending of funds are also provided through PNC Bank. Securities products, brokerage services, and managed account advisory services are offered by PNC Investments LLC, a registered broker-dealer and a registered investment adviser and member of FINRA and SIPC. Insurance products may be provided through PNC Insurance Services, LLC, a licensed insurance agency affiliate of PNC, or through licensed insurance agencies that are not affiliated with PNC; in either case a licensed insurance affiliate may receive compensation if you choose to purchase insurance through these programs. A decision to purchase insurance will not affect the cost or availability of other products or services from PNC or its affiliates. PNC does not provide legal, tax, or accounting advice unless, with respect to tax advice, PNC Bank has entered into a written tax services agreement. PNC does not provide services in any jurisdiction in which it is not authorized to conduct business. PNC Bank is not registered as a municipal advisor under the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Act”). Investment management and related products and services provided to a “municipal entity” or “obligated person” regarding “proceeds of municipal securities” (as such terms are defined in the Act) will be provided by PNC Capital Advisors.

“PNC Wealth Management,” “Hawthorn, PNC Family Wealth,” “Vested Interest,” “PNC Institutional Asset Management,” “PNC Retirement Solutions,” and “PNC Institutional Advisory Solutions” are registered service marks of The PNC Financial Services Group, Inc.

 

Investments: Not FDIC Insured. No Bank Guarantee. May Lose Value.

Insurance: Not FDIC Insured. No Bank or Federal Government Guarantee. Not a Deposit. May Lose Value.