We added short-term bonds to many portfolios (those with a moderate or lower allocation to stocks). Most received short-term Treasury Inflation Protected Securities (TIPS). In some taxable accounts, we prioritized tax efficiency and instead added short-term municipal bonds.

TIPS are harder to grasp than they seem. Here are a few basics:

• U.S. government bonds (backed by the full faith and credit)

• Principal increases with inflation

• Coupon payments are a fixed % of principal

  • Inflation ↑ → Principal ↑ + Coupons ↑

The trickiness results from investor expectations. Many expect that TIPS will appreciate with inflation. That’s not always the case (e.g., 2022). TIPS perform well when unexpected inflation occurs (e.g., 2021).

TIPS prices reflect market expectations of future inflation (a.k.a. the breakeven inflation rate). In the next chart, five-year Treasuries yield 4.21%, and five-year TIPS yield 1.93%. The difference, 2.38%, is the breakeven inflation rate. If inflation over the next five years averages more than the breakeven rate, then TIPS will have better results than the equivalent U.S. Treasury bond.

There are three main reasons why we added short-term TIPS:

1.    Reliable Liquidity for Distributions

Short-term bonds are one of the least volatile asset classes. Due to their lower risk, they typically pay investors similar income to cash. A few years ago, that meant a tiny fraction of 1%. Today, they pay 4-5%.  

For those receiving portfolio distributions, we periodically sell investments to deliver cash. We must balance two portfolio goals at tension: (a) long-term returns and (b) reliability, i.e., what will be an investment’s value when sold.

Short-term bonds provide a reliable resource to tap for cash during volatility elsewhere. While they are unlikely to provide outsized long-term returns, they bolster our ability to be patient with more volatile, higher growth assets. 

2.         Inflation Protection

Over long periods of time, stocks have been a reliable bulwark against inflation. In strong economies, companies can pass higher prices to consumers and deliver correspondingly higher earnings and stock prices.

In contrast, bonds often suffer in inflationary environments. In more conservative portfolios that hold fewer stocks, TIPS help reduce inflation risk.

3.           Diversify Bond Portfolios

Previously, most of our bond sleeve consisted of high quality, long maturity bonds. With low and declining interest rates in recent decades, these bonds have performed well overall. Of equal importance, they have appreciated during stock market declines.

Today’s elevated rates and inflation may herald a different environment for bonds. Short-term bonds may be better suited to meet investors’ goals: diversifying equities, capital preservation, income, and inflation protection.

Lastly, let’s be clear about what is not a reason we are adding TIPS – we are not forecasting higher inflation. Inflation is notoriously impossible to model and predict. We merely want to protect against the possibility.

We’re happy to discuss specific changes to your portfolio. Please reach out to your advisor.