New world disorder. The days of late cannot go by without some form of geopolitical or economic shock occupying the headlines. It is a rude awakening for the capital markets, which had initially cheered the perpetuation of American exceptionalism under President Trump’s second act in office. His barrage of tariffs and taunting of traditional US allies, however, have brought sentiment down to the doldrums – as growth is expected to be tepid in a world of uncertainty, while inflation remains sticky as tariff pains begin to bite.

Feeling TIPSy. That is not to say, however, that investors must sit idly by and watch their portfolios get decimated by volatility. In a niche corner of the bond markets lies an instrument that precisely caters for such uncertainty – one that does especially well in an environment of stagnant growth and higher inflation – and that is Treasury Inflation‑Protected Securities (TIPS). A brief explanation of its mechanism is helpful before we dive into the strategy proper.

How do TIPS work?

TIPS are government-backed securities issued with maturities of 5, 10, and 30 years, with coupons paid semi-annually. The security functions like a bond in essence, except for the use of an index ratio to adjust the principal and coupon payment to match the rate of inflation.

By way of illustration, suppose an investor owns USD1,000 in TIPS with a coupon rate of 1%. If there was no inflation as measured by the CPI, then the principal of the bond remains at USD1,000 and the coupon received for the year would be USD10 (1% x USD1,000). However, if inflation rises by 2% at the end of the year, then the principal is adjusted by the index ratio of 1.02 to become USD1,020, while the coupon payment concurrently rises to USD10.20 (1% x USD1,020). Note that this works both ways; the principal and coupon can also be adjusted downward under deflationary scenarios, but the investor is accorded a certain degree of downside protection as they redeem the higher of the adjusted principal or the original principal at maturity.

TIPS did not protect against the inflation spike of 2022. This would not be the first time that we have opined on this instrument. In anticipation of higher inflation, investors were quite keen to explore TIPS at the end of 2021 in what was seemingly a good idea to hedge against a sudden spike in prices. Back then, however, our stance was not one of embrace, but rather caution, seeing that TIPS (real) yields were negative – meaning that prices were already bid up so high that investors were assured negative returns from the pull to par effect (without the inflation adjustment of the index ratio). Notwithstanding, TIPS did outperform US treasuries in that same inflationary period, but that outperformance was not good enough to prevent it from clocking negative total returns in 2022 like the rest of the fixed income markets. Investors that favoured TIPS over treasuries had the consolation of a participant who came in second last in a beauty contest – their investment mitigated some losses but was far from living up to its namesake as an inflation protector.

Real yields at a tipping point. The biggest headwind at the time was clearly the Fed’s aggressive rate hiking cycle, pushing real yields up to a 16-year high within a short span of 1.5 years. The difference for TIPS today, we believe, is that real yields have plateaued as the Fed has already begun a rate cutting cycle. Unless the Fed makes a complete u-turn and hikes rates again – which amounts to a calamitous blunder in forward guidance – the biggest headwind for TIPS is largely behind us. Moreover, a slowdown in growth, as several economic indicators seem to be flashing, implies that the Fed may need to bring down the levels of real rates in due time to provide further accommodation to the economy. Such turning points are often the greatest opportunities for nimble investors to capitalise on.

Breakevens have underestimated actual inflation. Why did TIPS outperform nominal treasuries? We compared 5Y breakeven inflation rates against the actual TIPS CPI adjustment 1Y forward and found that breakevens had persistently underestimated the strength and persistence of actual inflation – for more than five years in a row now (Figure 3). Breakeven inflation hardly moved beyond its tight range of 2-3% despite headline CPI soaring to 9% and beyond (recall that nominal yield = real yield + breakeven inflation). Given that the ongoing threat of tit-for-tat tariffs presents upside risks to CPI prints, one could say that 5Y US breakeven inflation rates at around just 2.5% today appear complacent; surely a security with inflation-hedging characteristics can provide the optionality that would be valuable in uncertainty.

Other potential considerations. As an inflation hedge, TIPS yields and gold have had near perfect correlations before 2022 (Figure 4). Something drastic had occurred in that year which forced a decoupling of these inflation hedges, – you guessed it – war. As the US unilaterally froze USD300bn in Russian foreign holdings at the start of Moscow's invasion of Ukraine, countries were forced to make distinctions between TIPS and gold – the former is a debt instrument, while the latter was a neutral reserve asset. While we remain positive on gold, our take is that this decoupling cannot diverge forever; eventually the real yields on TIPS become enticing enough versus the yellow metal that pays no interest.

Ultra-long duration TIPS look attractive. For all our caution on duration, TIPS is one instrument that we have a favorable long duration view, given that the TIPS curve is very steep (Figure 5) – investors are adequately compensated for going long. Given the level of indebtedness in the US, it makes little sense for debt sustainability if real yields remained positive for the very long term. Also, this is one debt instrument that the US cannot “inflate away”, given that the principal adjusts with inflation. The Trump administration appears to be serious about the issues of debt sustainability (for now), which is a small plus given that TIPS are ultimately backed by the creditworthiness of the US government.

The bond that beats stagflation. Finally, as a reminder, TIPS sit uniquely in the upper left space of the growth-inflation quadrants for fixed income investing as the only security that performs well in stagflation (Figure 6). Yet TIPS, we believe, does not need stagflation to perform well. Just like the most of the fixed income markets, yields today are high enough for decent recurring income – for TIPS, however, more than a hedge for slower growth, mechanisms ensure that the purchasing power of future coupon payments are commensurate with inflation. What’s not to like?