Fixed income investments have historically been less volatile than stocks, which makes them an effective tool to dampen the volatility of your investment portfolio. With the yield on the 10-year Treasury Note at 1.20%, fixed income investors are not likely to earn a high return unless interest rates fall dramatically. Instead, interest rates have been rising since March 2020. Another key benefit to holding fixed income investments is diversification, with the end goal being to own an asset class that rises when another asset class falls. There have been times in the past when fixed income investments have appreciated at the same time stocks have fallen. The COVID-related bear market last year was the most recent example of this pattern.
The biggest risk to fixed income investments is inflation: a general increase in prices and a fall in the purchasing value of money. Inflation can be caused by the demand for goods exceeding the supply of those goods, which in turn causes the prices of those goods to rise. Fixed income investors are essentially lenders: you are lending your money to someone else in exchange for a payment in the future, but inflation has the potential to make those future payments decrease in value in comparison to their current value.
Treasury inflation-protected securities (TIPS) are not exposed to the risk of inflation, as their principal and interest are adjusted higher for inflation (which is measured by the Consumer Price Index). The interest from TIPS is still taxable, so investors tend to own them in tax-deferred accounts.
Over the last five years, both investments have tended to move in similar directions, as indicated in the chart above illustrating the performance of TIPS (ticker: TIP) versus the Vanguard Intermediate-Term Bond Index ETF (ticker: BIV). We first introduced TIPS in June 2020—denoted by the green arrow—when investors were more concerned with the economic fallout from the pandemic and were underestimating the coming economic recovery. At the time, we predicted that the economy would recover given all the stimulus initiatives implemented by governments worldwide, and in turn investors would increase their estimates for inflation. Since then, TIPS have outperformed the more traditional bond index fund by over 5%.
We believe that TIPS offer a better risk-reward ratio than traditional fixed income investments and deserve a place in portfolios. We will continue to monitor economic conditions and the factors that influence inflation—including wage growth—that signal the economy is not recovering as predicted. If the signs point to depressed economic recovery, we would recommend exiting TIPS in favor of traditional fixed income investments.