TIPS (Treasury Inflation-Protected Securities) are US government bonds that provide a specific after-inflation return (i.e., “real return”) as compared to traditional “nominal” bonds which provide a specific before-inflation return.
We’ve discussed before when it makes sense to use individual TIPS as opposed to TIPS funds. But we’ve never discussed when to use TIPS at all — as opposed to nominal Treasury bonds.
What Inflation Do You Expect?
The most obvious way to choose between TIPS and nominal treasury bonds is to compare the market’s inflation expectation to your own inflation expectation.
For example, as I’m writing this, the yield on 10-year TIPS is 1.01%, and the yield on a 10-year nominal Treasury bond is 2.64%. What we can conclude here is that the market is estimating inflation will average roughly 1.63% (2.64% minus 1.01%) per year over the next decade.
If you expect inflation to be above the market’s expectation (1.63% in this case), TIPS are a better bet. If you expect inflation to be below the market’s expectation, go with nominal bonds.
What if you don’t have any guesses about inflation?
Of course the above analysis isn’t particularly helpful if, like me, you don’t spend much time pondering what the rate of inflation will be over any given period. If that’s the case, you’ll have to come up with another way to choose your allocation between TIPS and nominal bonds.
In such a scenario, the most important differences between TIPS and nominal bonds are that:
- TIPS make planning easier, but
- Nominal bonds may be more useful as a diversifier of a mostly-stock portfolio.
Using TIPS for Planning
In almost every situation, inflation-adjusted returns are more meaningful than nominal returns. As such, TIPS’ inflation-adjusted yield makes them much more useful for planning purposes.
For example, TIPS can be an excellent tool for retirement portfolios. While they’re not risk-free, TIPS can be used to provide a high degree of safety for sustaining a given (low) inflation-adjusted withdrawal rate (e.g., liquidating 3% of your portfolio in your first year of retirement, then increasing the dollar amount that you liquidate each year in order to keep up with inflation).
Bonds as a Diversifier
If you’re only holding a small amount of bonds, and you’re doing it solely to reduce the volatility of a mostly-stock portfolio, nominal bonds may be the better bet. The reason is that, in crisis scenarios, investors tend to flock toward extremely safe investments — especially nominal Treasuries. As a result:
- Nominal Treasury bonds seem to perform better during market crashes, and
- Nominal Treasury bonds’ correlation to stock market returns has been lower than that of TIPS.
That said, TIPS are still relatively new, so these conclusions are based on a very small amount of data.