Aside from the traditional inflation hedges like gold, commodities and equities, Treasury Inflation-Protected Securities (“TIPS) usually come to mind. These securities are bonds issued by the U.S Treasury and are fully guaranteed. They are different from regular bonds in that the total return earned from income and principal is adjusted to reflect inflation over the time to maturity. How have TIPS done over the past few inflationary years in their role as an inflation hedge?
As we all know, the capital markets have all been up and down over the past five years. What we may not have realized is that TIPS (TIP) have not been too effective an inflation hedge. From the table below you can easily see that TIPS had a few good years and a few bad years; the bad years coming exactly when inflation peaked in 2022; actually DOWN -12.3% when inflation was up +8.0%!
The reasons for the underperformance have a lot to do with bond math and the low coupon rates that existed prior to interest rate increases that started in 2022. That same phenomenon impacted core bonds (AGG) in a similar manner causing its average annual return over the entire 5.3-year period to be only -0.1%! Over that longer time horizon TIPS did outperform core bonds, but not by much and certainly not enough to warrant an inflation hedge badge!
Also from the chart above, you can see that traditional inflation hedges like gold (GLD), core equities (IVV), and commodities (GSG) all handily beat TIPS and CPI (inflation) over that horizon. Interestingly, it is important to note that diversification in the fixed income universe paid off handsomely during this difficult period.
Aside from long term investment grade bonds (LQD) that have struggled in the face of higher rates, other fixed income sectors proved to be good diversifiers to help hedge inflation risk by outperforming core bonds. Short-term investment grade bonds (SLQD), high yield bonds (HYG), and bank loans (BKLN) all outperformed TIPS and managed to stay close or beat inflation. Some of that outperformance is due to a shorter bond duration and historically narrow credit spreads.
Dattilio & Ash has not been a buyer of TIPS during the prior market cycle. Higher rate levels today, however, may make TIPS a more interesting investment thesis going forward. Gold, on the other hand, with 20/20 hindsight could have been a viable investment option over the past few years. D&A had not been an investor in commodities due to their higher level of risk.
Instead, we have focused mostly on core equities and shorter duration fixed income sectors and have consistently had total fixed income duration shorter than that of core bonds. Shorter duration fixed income has less interest rate sensitivity and will outperform longer duration bonds when rates are rising in a Fed tightening cycle.
Core equities have been a good place to be as large stable companies are able to increase earnings due to inflationary pressures and D&A has been increasing allocations to this sector over the past several quarters. Other equity diversifiers, like small- and mid-cap equities, real estate investment trusts (REITs) and international and emerging market equities continue to struggle to keep pace with core equities but we continue to hold for diversification purposes.