SPY - LTPZ: Long-Term TIPS For The Long Run

2024-05-01 09:13:39 ET

Summary

• Long-term Treasury Inflation-Protected Securities (TIPS) are underpriced and a better component of a 60/40 portfolio than unhedged Treasuries.
• Simulated historical returns suggest long-term TIPS are a powerful hedge against high inflation and long-term bear markets in equities.
• The next two decades are likely to see higher inflation and an increased probability of a long-term bear market in equities.
• TIPS can be vulnerable to acute deflationary episodes but would still likely make for a better long-term diversifier than unhedged Treasuries.
• Long-term breakeven inflation rates are currently under 2.5%, but inflation is likely to be higher than 4% over the next 15-20 years.

Long-term Treasury Inflation-Protected Securities, or TIPS, such as those to be found in PIMCO’s 15+ Year U.S. TIPS Index ETF ( LTPZ ), are probably underpriced and make for a better component of a 60/40 portfolio than do unhedged Treasuries of similar duration such as those held in the iShares 20+ Year Treasury Bond ETF ( TLT ). For these two reasons, long-term investors who are interested in hedging against high inflation and/or low long-term stock returns should consider adding LTPZ to their holdings.

This assertion is based primarily on the assumption that breakeven inflation rates, the expected rate of inflation as implied by the yield of unhedged Treasuries less the yield in TIPS of identical maturities (see “ It’s Time to Consider TIPS ” for a rundown on how TIPS are constructed and priced), are driven primarily by contemporary long-term inflation rates, and that this tends to lead to mispricing of long-term TIPS. Using this assumption, I have estimated historical would-be returns for long-term TIPS going back to the 1870s. That is, assuming that investors would have priced TIPS-style instruments based on their recent experience of inflation, I have projected or ‘backcasted’ ‘historical’ TIPS returns to that period, even though TIPS were not issued until 1997 .

Comparing the long- and short-term returns of this backcasted TIPS index with the returns of unhedged Treasuries and equities suggests that long-term TIPS are a powerful hedge against both unexpectedly high inflation (no surprise there) and long-term bear markets in equities, even when accounting for the tendency of unhedged Treasuries to outperform both equities and TIPS in acute deflationary conditions (e.g., the Great Depression)....

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