Is Your Portfolio Prepared for Inflation?

Inflation has been under the radar for the last several years, hovering well below historical averages. This backdrop boosted stocks, longer-maturity U.S. Treasuries and other assets that benefit from low inflation.

Nevertheless, several factors suggest higher inflation may be on the horizon, which underscores the importance of hedging a portfolio’s inflation risk. Treasury Inflation-Protected Securities (TIPS) are one way to do that.

Inflation Faces Pressure on Three Fronts

We believe three key factors—the Federal Reserve (Fed), the federal government and COVID-19—ultimately will drive inflation higher.

1. Two key components of current Fed policy—ultra-low interest rates and quantitative easing (QE)—likely will lead to higher inflation over time due to the increased amount of money in the economy.

In addition, the Fed recently replaced its 2% inflation target with a flexible approach aimed at achieving an average inflation rate of 2%. This means the Fed will allow inflation to run modestly higher than 2% to make up for periods of low inflation.

2. Fiscal policy, including massive federal government spending and deficits, may eventually push inflation higher. And if the Biden administration embarks on a re-regulation campaign, it could also lead to a broad range of price hikes.

3. Fallout from the pandemic may have inflationary implications. Specifically, a backlash against globalization could prompt the federal government to take steps to encourage domestic production of strategic goods, which could drive prices higher.

While the rollout of COVID-19 vaccines should bring a return to normal life—and normal spending patterns—supply and demand imbalances due to the pandemic could trigger higher prices. From a broader perspective, the combination of a weaker U.S. dollar and improving global growth stemming from pent-up demand likely will lift goods prices.

Even Low Inflation Can Do Long-Term Damage

On the surface, the Fed’s goal of a 2% (or slightly higher) rate of inflation seems relatively low. However, even small increases in the average inflation rate can diminish a portfolio’s purchasing power over time.

Consider this: Over the last 25 years, inflation has averaged 2.14%.* But that relatively modest rate has translated to a significant loss of purchasing power. For example, at that rate of inflation, an item that cost $100 in 1996 would cost approximately $165 today.

How can investors position their assets to avoid lasting damage from inflation? An allocation to TIPS may help.

TIPS Seek to Preserve Your Purchasing Power

TIPS are a class of U.S. Treasury securities designed to help protect investors from the long-term, corrosive effects of inflation. Unlike nominal Treasuries, the face value of TIPS changes along with the inflation rate. As inflation rises, the principal value of the security increases, creating a steadily growing stream of interest payments.

Nominal Treasuries TIPS
Backed by the U.S. government Backed by the U.S. government
Fixed interest rate; interest paid twice a year Fixed interest rate; interest paid twice a year
Principal value remains constant Principal value adjusts monthly based on Consumer Price Index (CPI)
Maturities range from four weeks to 30 years Maturities of five, 10 and 30 years
Interest payments remain constant throughout the security’s life Interest payments adjust along with the security’s principal value

At maturity, the TIPS owner receives the original principal value plus the sum of all the inflation adjustments. Of course, the opposite is true in periods of deflation, which would cause the principal value of TIPS and the interest payments to decline.

How TIPS Adjust With Inflation 

This hypothetical example assumes a five-year TIPS and a five-year nominal Treasury, each with a face value (principal) of $1,000 and a fixed coupon rate (the set interest rate assigned to a security when it’s issued) of 3%. For simplicity, this chart assumes one annual interest rate payment and one yearly principal value adjustment (rather than monthly).

This hypothetical situation contains assumptions that are intended for illustrative purposes only and are not representative of the performance of any security. There is no assurance similar results can be achieved, and this information should not be relied upon as a specific recommendation to buy or sell securities.

TIPS Have Historically Outpaced Inflation

TIPS have shown to be an effective long-term hedge against inflation, significantly outpacing the Consumer Price Index over time. 

TIPS Have Outpaced Inflation

Data from 1/31/1999 – 12/31/2020. Sources: Bloomberg Barclays U.S. TIPS Index, U.S. Bureau of Labor Statistics (CPI-U, U.S. City Average). Chart is indexed at 100 to compare values.

In addition to handily beating inflation over time, TIPS have outperformed commodities—also an inflation-hedging asset class—as well as diversified core bonds.

While many investors have used gold and other commodities as inflation hedges, these assets also have been subject to sharp volatility. TIPS, on the other hand, have historically delivered less volatile performance over time. So along with their inflation-fighting qualities, TIPS may also offer attractive risk-adjusted, long-term performance potential in a diversified portfolio. 

TIPS May Fight Inflation With Less Volatility

Data from 1/31/1999 – 12/31/2020. Sources: Bloomberg Barclays U.S. Aggregate Bond Index (U.S. core bonds); Bloomberg Barclays U.S. TIPS Index (U.S. TIPS); S&P GSCI (commodities); U.S. Bureau of Labor Statistics, CPI-U, U.S. City Average (U.S. Consumer Price Index).

What About Interest Rate Risk?

Because TIPS are Treasury securities, they’re backed by the U.S. government and contain virtually no credit risk. However, like all bonds, they are subject to interest rate risk.

In general, TIPS have the potential to perform better than nominal Treasuries in a rising interest rate environment—as long as rates are rising along with inflation. The inflation-adjustment feature of TIPS is designed to provide price protection. Nominal Treasuries don’t have this feature, and their prices typically decline when rates rise. However, if interest rates rise while inflation remains low or flat, TIPS prices could decline.

Bottom Line

We believe that TIPS’ potential for inflation protection, positive real (inflation-adjusted) returns, diversification and potential risk reduction makes them an attractive component in a well-rounded portfolio.

Are You Ready for Inflation?

We can help you position your portfolio for what’s to come.

*Source: Consumer Price Index. Annual inflation data from 1995 – 2020.

Past performance is no guarantee of future results. Investment returns will fluctuate and it is possible to lose money.

The opinions expressed are those of American Century Investments (or the portfolio manager) and are no guarantee of the future performance of any American Century Investments' portfolio. This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.

Investments in fixed income securities are subject to the risks associated with debt securities including credit, price and interest rate risk.

In certain interest rate environments, such as when real interest rates are rising faster than nominal interest rates, inflation-protected securities with similar durations may experience greater losses than other fixed income securities. Interest payments on inflation-protected debt securities will fluctuate as the principal and/or interest is adjusted for inflation and can be unpredictable.

Generally, as interest rates rise, the value of the securities held in the fund will decline. The opposite is true when interest rates decline.

The information is not intended as a personalized recommendation or fiduciary advice and should not be relied upon for, investment, accounting, legal or tax advice.

Diversification does not assure a profit nor does it protect against loss of principal.

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