TIPS with Chuck ThomasLauren Virostek: Hello, and welcome to Vanguard’s Investment Commentary podcast series.             ...
Consumer Price Index. So the principal rises and coupon payments rise with inflation overtime. So, in some sense, they’re ...
Lauren Virostek: Chuck, is there any real difference between short- and long-term TIPS? Andif so, what are the trade-offs ...
Vanguard FinancialAll investing is subject to risk, including the possible loss of principal.                             ...
Upcoming SlideShare
Loading in...5
×

Tips

1,387

Published on

How do TIPS compare with other assets for inflation hedging, returns, and volatility.

Published in: Economy & Finance
0 Comments
0 Likes
Statistics
Notes
  • Be the first to comment

  • Be the first to like this

No Downloads
Views
Total Views
1,387
On Slideshare
0
From Embeds
0
Number of Embeds
2
Actions
Shares
0
Downloads
0
Comments
0
Likes
0
Embeds 0
No embeds

No notes for slide

Transcript of "Tips"

  1. 1. TIPS with Chuck ThomasLauren Virostek: Hello, and welcome to Vanguard’s Investment Commentary podcast series. Meet the speakerI’m Lauren Virostek. In this month’s episode, which we’re taping on October 24, 2012, we’regoing to focus on Treasury Inflation-Protected Securities, commonly known as TIPS. Joiningus by telephone is Chuck Thomas, an analyst in Vanguard’s Investment Strategy Group.Welcome, Chuck.Chuck Thomas: Thanks, Lauren. Great to be here.Lauren Virostek: Before we get started on TIPS, can you describe Vanguard’s currentoutlook on inflation? Chuck ThomasChuck Thomas: Absolutely. And that’s really the central question when it comes to TIPS. Vanguard InvestmentWe don’t like to say, here is Vanguard’s outlook for inflation and pin down any one number. Strategy GroupThere are a number of factors that kind of go into our view in inflation. Wage inflation levelsare right now very low, demand is quite constrained with very high unemployment, and mostimportantly, expectations for inflation are quite in line with what the Fed’s long-run target of2% is right now. So, all of those factors combined lead us to conclude that there is about aone-third chance over the next ten years that inflation will be relatively moderate in line withthe Fed’s target in the range of about 1% to 3%.That said, there are risks to that outlook both on the upside and downside. On the downside,and that is mainly what the Fed, the central bank, is concerned about right now, there is therisk of deflation, so inflation less than that 1% target. At the same time, there is a risk thatinflation will be higher than that 1% to 3% central range, and that is really what TIPS are therefor an investor to address, that risk of higher-than-expected inflation.Lauren Virostek: And taking all of that into consideration, how should an investor think aboutinflation protection in a portfolio?Chuck Thomas: There are really two ways an investor can address the risk of inflation whenthey’re choosing investments and designing a strategic asset allocation. One avenue to take,and this is perhaps a more traditional approach, you go about choosing assets that you expectto have a higher return offer, a higher risk premium, than that inflation expectation over thelong run. So there is certainly a risk that those assets may deviate from that expectation, butover a long enough time horizon your best guess is that they will outperform inflation.So what would some assets like that be? So stocks would be a great example. Corporatebonds and nominal bonds would also offer a similar approach to addressing inflation ina portfolio.The second way to address inflation in portfolio construction is where you choose assets thatare highly correlated with inflation over a short time horizon. Now, TIPS fit this descriptionquite nicely. They have an indexation mechanism, where their principal is indexed to the (continued on page)
  2. 2. Consumer Price Index. So the principal rises and coupon payments rise with inflation overtime. So, in some sense, they’re the ideal asset for this kind of inflation-tracking strategybecause their income is directly derived from movements in inflation.Lauren Virostek: So, Chuck, in a world with positive inflation, wouldn’t TIPS always be thebetter investment option?Chuck Thomas: That’s a great question, Lauren, and it reflects some, perhaps, confusionthat many investors have about the role TIPS can play in a portfolio. TIPS, in some sense,really only compensate you for unexpected inflation. You are taking the market’s expectationof inflation, discounting it back to today, and then the only income that you gain over anominal Treasury security, say, is when inflation departs from that expectation. So wheninflation is higher or lower than expected, your TIPS returns will reflect that. So, to answeryour question, no, we wouldn’t expect TIPS to always be a better option relative to othersecurities just because inflation is positive. What matters much more when you’re evaluatingTIPS relative to other investments is, whether inflation is higher or lower than expected overyour investment horizon.Lauren Virostek: And what are some reasons that an investor would invest in TIPS ratherthan in gold or other commodities?Chuck Thomas: Oftentimes TIPS will get lumped in with those other categories of assetsas a kind of inflation hedge. So while gold or commodities may have similar correlations toinflation as TIPS do, depending on the time horizon, one thing that’s very different betweenTIPS and those other asset classes is their levels of volatility. So focusing on inflationcorrelation or inflation tracking is kind of one part of the story. The other thing we want toevaluate is how well these assets fit in the context of a diversified portfolio. In that sense,gold and commodities can potentially add risk because of their volatility levels.So to give you an example based on all the history we have, the volatility on a portfolio ofbroad TIPS back to 1997, since their inception, average annualized volatility has been about5%. For gold and commodity futures, it’s been quite a bit higher. So gold has been closeto 30%, commodity futures about 25%. So what investors should be looking at is not onlythe inflation-tracking ability of these assets, but also the impact to their portfolio when theyincorporate return expectations, and importantly, volatility expectations.Lauren Virostek: Chuck, can you describe real duration and how it’s different from theduration on a typical bond portfolio?Chuck Thomas: Duration is simply a measure of any bond’s sensitivity to its movements inits interest rate. So in nominal bonds, that basically measures, for a given move in that bond’sinterest rate, how much is the price moving. Duration is expressed in years. Higher numberof years means more movement in the price for a given level of interest rate movement.For TIPS—because the relevant interest rate for those investments is a real interest rate (Sothat’s the interest rate with both inflation expectations and that risk premium for bearinginflation. We strip those out and we’re left with the real rate.)—that’s the real return aninvestor would expect to earn after inflation. TIPS prices are sensitive to that real rate, not thenominal rate.Real duration and nominal duration are measuring two different things. Real rates and nominalinterest rates, depending on movements in inflation expectations, can move in very differentdirections. So although a portfolio of TIPS and nominal bonds may have similar durationmeasures, they can actually exhibit very different performance over time, depending onhow real rates and nominal rates move. (continued on next page)
  3. 3. Lauren Virostek: Chuck, is there any real difference between short- and long-term TIPS? Andif so, what are the trade-offs between the two investments?Chuck Thomas: That’s a great question, and it follows nicely from our discussion on realduration. All TIPS, regardless of their maturity, have the same inflation indexation mechanism.So absent any movement in real interest rates, we would expect a short-term TIP and along-term TIP to have the same return because their income payments are going to begenerated from the same source.Now, the difference between them is that they have very different real durations. So whenreal interest rates do shift over time, the performance of a short TIP versus a long-term TIPcan be very different, and we see that if we look back over history. Short-term TIPS havebeen much less volatile than long-term TIPS and much less sensitive to changes in realinterest rates. Now, this has two results. So first, it allows the income payments that aresensitive to inflation to drive a much larger proportion of the short-term TIPS return. Becausethe price isn’t moving around due to real interest rate changes, you get more of that incomeand see more of that inflation sensitivity.The other aspect that increases short-term TIPS’ sensitivity to inflation is the fact that theirprices are driven more by movements in inflation expectations themselves. So when youhave a move in inflation, short-term TIPS reflect that information much better than long-termTIPS do.So when we think back to the reasons for including inflation-sensitive assets in a portfolio,there is a trade-off between short-term TIPS and long-term TIPS. Short-term TIPS offer betterinflation-tracking properties. Long-term TIPS typically have a higher expected return becauseof higher real interest rates. So, in that sense, one isn’t necessarily better than the other.They just offer different properties and fit differently in a portfolio, depending on what aninvestor is looking for.Lauren Virostek: So, Chuck, what would you suggest advisors tell their clients aboutinvesting in TIPS right now?Chuck Thomas: I think the most important thing that advisors need to keep in mind is thatthere are always trade-offs to any strategy. So you can certainly increase a portfolio’s trackingor correlation to inflation, but this is also going to come at a cost, either a give-up in expectedlong-run return or increased volatility. There is no free lunch with inflation protection. Sowhenever an investor is considering an allocation to inflation-sensitive assets, we wouldencourage that they evaluate the trade-offs with this decision.Lauren Virostek: Great. Thank you so much for talking to us today, Chuck.Chuck Thomas: Thanks, Lauren.Lauren Virostek: We hope you enjoyed this Vanguard Investment Commentary podcast.Be sure to check back with us each month for more insights on the markets and investing.Thanks for listening.
  4. 4. Vanguard FinancialAll investing is subject to risk, including the possible loss of principal. Advisor Services™Bonds and Bond funds are subject to the risk that an issuer will fail to make payments on time, and that bond prices will P.O. Box 2900decline because of rising interest rates or negative perceptions of an issuer’s ability to make payments. Valley Forge, PA 19482-2900U.S. government backing of Treasury or agency securities applies only to the underlying securities and does not preventshare-price fluctuations.Diversification does not ensure a profit or protect against a loss in a declining market. © 2012 The Vanguard Group, Inc. All rights reserved.Be aware that fluctuations in the financial markets and other factors may cause declines in the value of your account. Vanguard Marketing Corporation, Distributor.There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provideyou with a given level of income. TIPSTR 112012

×