Do TIPS Work?
Steve LeCompte | December 17, 2009 | Bonds, Economic Indicators
Are Treasury Inflation Protected Securities (TIPS), for which the
Treasury adjusts the principal based on the Consumer Price Index
for all urban consumers (CPI-U), effective as an inflation hedge?
In their September 2009 paper entitled “A TIPS Scorecard: Are
TIPS Accomplishing What They Were Supposed to Accomplish?
Can They Be Improved?”, Michelle Barnes, Zvi Bodie, Robert
Triest and Christina Wang evaluate the progress of the TIPS
market toward providing: (1) consumers with a hedge against real
interest rate risk; (2) holders of nominal bonds with a hedge
against inflation risk; and, (3) everyone with a reliable indicator of
expected inflation. Using inflation rate and bond yield data
available since the introduction of TIPS in September 1997, they
conclude that:

TIPS provide a good real-return hedge, despite CPI
measurement error and possible demographic differences
among TIPS investors. TIPS indexed to CPI are as good
as TIPS indexed to other inflation measures, because
inflation risk is largely independent of the measure used.

TIPS better protect long-term, buy-and-hold investors
than investors who hold TIPS for less than the full
maturity. Over relatively short horizons, bond price
volatility overwhelms the relatively small deviations
between actual and expected inflation.

The inflation rate implied by the difference in yields
between nominal Treasury and TIPS markets are neither
clean measures of expected future inflation nor likely to
be good predictors of future inflation (see chart below).

A “ladder” of TIPS, with maturities linked to anticipated
expenditure timeframes, would help investors in or near
retirement hedge against inflation in nominal expenses
over time.
The following chart, taken from the paper, shows in simplified
form how the nominal Treasury yield can be broken down into a
TIPS part (expected real rate plus a real rate risk premium) and an
inflation compensation part (expected inflation plus an inflation
risk premium). This diagram illustrates why there is no easy way
to extract the expected inflation rate from the difference between
nominal and TIPS yields.
In summary, TIPS work reasonably well as an inflation hedge for
long-term holders, but they are not particularly useful in
measuring inflation expectations.