VTIP - VTIP: High Yield With Minimal Risk

Summary

• Treasury Inflation-Protected Securities are among the most attractive asset classes at present based on their expected returns relative to their downside risk.
• With a real yield of 1.9%, the Vanguard Short-Term Inflation-Protected Securities ETF offers relatively strong returns while protecting against a continued rise in long-term UST yields.
• 2-year TIPS yields are now 2 percentage points and a full standard deviation above their long-term average, putting intense pressure on the real economy.
• A return back to zero real yields in line with the long-term average would result in gains of around 8%, potentially resulting in 10% gains over the next 12 months.

Treasury Inflation Protected Securities are among the most attractive asset classes at present based on their expected returns relative to their downside risk. I wrote last week about the relatively high yield and potential upside for the iShares TIPS Bond ETF ( TIP ), and I believe the risk-reward outlook may be even stronger for short-term TIPS. Last, I covered VTIP was in Aug 2022. With a real yield of 1.9%, the Vanguard Short-Term Inflation-Protected Securities ETF ( VTIP ) offers relatively strong returns with minimal downside risk in the event of a collapse in inflation expectations or a continued rise in yields.

The VTIP ETF

The VTIP tracks an index of US Treasury Inflation-Protected Securities with less than 5 years remaining to maturity, and has an average effective maturity of 2.7 years. The real yield to maturity now sits at 1.9%, meaning that investors should expect to receive 1.9% per year over the next few years in addition to the average rate of CPI over this period. The VTIP is ideal for investors looking to take advantage of high short-term yields while also protecting against continued elevated inflation. The low duration of 2.6 years also ensures that volatility will remain low relative to longer-dated TIPS. Even as real bond yields have surged over the past 12 months, the VTIP has lost just 4%, versus a 13% loss for the TIP. Of course, this lower level of volatility means less upside potential, but I still expect to see capital gains add a few extra percentage points to returns over the course of the this year and real yields move lower.

Solid Real Yield With Upside Potential

The current yield on the VTIP is extremely high relative to its long-term average. The chart below shows the yield on 2-year US TIPS, which the VTIP yield to maturity closely follows. It is now 2 percentage points and a full standard deviation above its long-term average going back to 2005. The high real yield of 1.7% reflects the 4.6% nominal 2-year yield and 2-year inflation expectations of 2.9%.

The US economy is heading towards a deep recession as the sharp spike in real borrowing costs is undermining the bubble areas of the economy that previously benefited from ultra-loose monetary policy. The Fed is likely to be forced to reverse its rate hiking policy over the coming 12 months to ease the burden on borrowers. Assuming no change in the inflation outlook, this would result in capital gains for the VTIP. A return back to zero real yields in line with the long-term average would result in gains of around 8%, potentially resulting in 10% gains over the next 12 months. Should we see inflation expectations rise as a result of interest rate cuts, capital gains for the VTIP would be even stronger.

Downside Risks Are Minimal

Of course, there is also the risk that the Fed keeps its foot on the break and real yields move higher. Failure to act swiftly enough to lower rates during the 2008 global financial crisis saw real yields spike to near 7% as inflation expectations collapsed, causing the short-term TIPS to lose 10% from peak to trough. A repeat of this cannot be ruled out, but even a 10% loss would be something of a worst-case scenario.

In addition to the VTIP facing much less downside risk in the event of a collapse in inflation expectations relative to longer-dated TIPS, it also faces less risk due to the extreme level of yield curve inversion. The 2s-10s curve is now 80bps, its highest level since 1981. The risk for longer-dated TIPS is that continued upside pressure on near-term yields causes renewed upside for long-term yields.

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