Skip to content

The Once in a Decade Bond Opportunity

On the low cost of inflation protection and environments where TIPS historically outperform Treasuries.

By Adam Collins On 2 min read
Poker player going all-in with their chips.

Last summer I wrote about a mispricing in the bond market in 2008 and wondered if we’d ever see something like it again.

As of March 20th, markets are (once again) giving away inflation protection for next to nothing.

The chart below shows the breakeven inflation rate. This is the level of inflation where Treasuries and Treasury inflation-protected securities (TIPS) will earn identical returns:

10-year breakeven inflation rate with steep drop in 2020.
Source: FRED

If future inflation is higher than the starting breakeven rate, TIPS will outperform Treasuries. With the breakeven rate near an all-time low, TIPS are extremely cheap. TIPS are different than a regular bond in two ways:

  • The principal value is adjusted higher with inflation.
  • Coupons are based on this adjusted principal.

If you buy a regular bond for $1,000 with a 1% yield, you’ll earn $10 per year in interest and $1,000 back at maturity. But let’s say you buy a TIPS bond and inflation is 2% in the first year. The principal will increase to $1,020. And if the bond yields 0.5%, then you’ll earn $5.10 in interest.

Given current breakevens, a 10-year TIPS bond will outperform a 10-year Treasury if inflation is higher than 0.5% per year over the next decade. The last time this happened was during the Great Depression:

Compound inflation rate over the prior 10 years.
Source: FRED

Even if things do get that bad, TIPS have a built-in deflation floor.

TIPS have significantly outperformed Treasuries following periods of low breakeven rates. When breakevens were below 1.75%, over the next year TIPS went on to outperform Treasuries by 3.6% on average:

TIPS relative performance based on high and low starting breakeven inflation rates.
TIPS performance data uses TIP and VIPSX, using VIPSX when data for TIP is unavailable. Treasury performance data uses IEF. These are all intermediate-term bond ETFs with similar durations. Data includes reinvested bond interest. These are hypothetical results, are not an indicator of future results, and do not represent returns an investor actually earned.

The biggest misconception about TIPS is that they’re only worth investing in when inflation is high. As the above chart shows, the main thing that matters is the starting breakeven rate.

Inflation protection is chronically missing in most portfolios I review. If you don’t have TIPS, now is a great time to buy them. Especially in an environment where governments are willing to spend whatever it takes to save the economy:

News headline about Washington poised to spend more than $1 trillion into the U.S. economy.

I personally own Vanguard’s VTIP ETF and it makes up half of the bond exposure in all client accounts.

Summary

  • Inflation protection is extremely cheap.
  • The 10-year breakeven inflation rate is 0.5% and inflation hasn’t been that low since the 1930s.
  • TIPS have historically outperformed Treasuries after starting breakevens were at current levels.