Treasury Inflation-Protected Securities (TIPS) are one of the few assets that offer a reliable hedge against inflation.  TIPS are a form of U.S. Treasury Bonds that are indexed to inflation.  So, when inflation rises, the government raises TIPS prices by a proportionate amount to compensate.

Years of finance research have shown that almost all other assets (like stocks, bonds, cash, real estate, and gold) are remarkably inconsistent and weak hedges against rising inflation.  One study by Bekaert and Wang in 2010 went so far as to say:

• “In short, it is next to impossible to use an individual asset or a portfolio of assets to adequately hedge inflation risk.”

Despite this conclusion, Bekaert and Wang were able to rank the limited inflation-hedging capacity of assets from worst to best as follows:

• Stocks
• Conventional Treasury Bonds
• Treasury Bills
• Foreign government bonds
• Real estate
• Gold.

This is why the built-in inflation protection of TIPS is extremely attractive for investors who are worried about potential future surges in inflation.

However, TIPS have only been around since 1997.  And in that time, Portfolio Visualizer data indicate that annual inflation has averaged a historically mild 2.3% with a peak of just 3.4% in 2005, excluding last year’s unexpected jump to 7.0%.  In contrast, during the prior 25 years, annual inflation averaged 5.6% with a peak of 13.3% in 1979.  It seems that the government invented TIPS just in time for obsolescence.  So, last year represents the first opportunity in history to see how TIPS perform when inflation rises substantially.

Further, last year’s inflation spike was initially dismissed as “transitory” and the persistence of high inflation into 2022 was a surprise to both investors and the conventional Treasury bond markets, which reflect investor expectations about future inflation.  Consequently, last year was particularly auspicious for the automatic inflation protection offered by TIPS exactly because no one was expecting a large and persistent rise in inflation.

So, in today’s post, I want to examine how TIPS, the only clear inflation hedge available, performed in 2021 as compared to other common asset classes.

Last Year’s Story

This graph shows the nominal (not inflation-adjusted) total 2021 returns of 14 asset classes from Portfolio Visualizer as compared to the 7% rate of inflation shown by the black horizontal line.  Types of stocks are shown in blue, types of bonds are shown in orange, and alternative assets of real estate (proxied by REIT stocks) and gold are shown in green.

Focusing on bonds for a moment, TIPS¹ were indeed the outstanding bond performer for 2021, with a nominal return of 5.6%.  All other types of bonds lost nominal money last year.  However, TIPS surprisingly lost inflation-adjusted money because their nominal returns were about 1.4% below the annual rate of inflation.  In my view, it’s pretty disappointing to lose inflation-adjusted money from an asset that includes an explicit inflation adjustment.

In contrast, we can see that real estate (REITs) and stocks of all types managed nominal returns well above the level of inflation in 2021.  Even though Bekaert and Wang ranked stocks as a poor inflation hedge, the lack of correlation between stocks and inflation necessarily means that stocks must sometimes perform well when inflation spikes.  And 2021 seems to have been one of those times.  Bekaert and Wang ranked real estate as a better inflation hedge, which is supported by the stellar performance of REITs last year.  But on the other hand, they ranked gold as the strongest inflation hedge, and yet gold had the second to worst returns performance in 2021.  That’s a good example of why even gold can be considered a pretty poor inflation hedge.

The History of TIPS

Last year suggests that during times of unexpectedly high inflation, TIPS may perform better than most bonds but still deliver lower absolute returns than many other assets.  However, last year may have been an anomaly for some reason.

As I already mentioned, inflation was pretty tame during the short history of TIPS, which makes it difficult to examine the potential benefits of TIPS.  Nonetheless, inflation did rise between about 0.8% and 2.6% in 6 of the last 25 years, which is better than a complete absence of data on rising inflation conditions.

At a broad level, we would expect TIPS to perform better in years when inflation is rising, and worse in years when inflation is sinking.  To see if this is true, I plotted the change in annual inflation for each year since 2001 against TIPS annual returns as shown in this graph.

In actual practice, TIPS don’t show a clear relationship with changes in inflation, regardless of whether those changes were expected or not.

Perhaps, we would see a better relationship if we look at only the 6 years (plus 2021) that had relatively larger positive changes in inflation.  Here’s that plot.

Despite the unusually high spike in inflation, 2021 TIPS returns were muted relative to past years with relatively mild rising inflation.  In these 7 years, the weak relationship between inflation and TIPS returns is the opposite of what you’d expect.  Clearly, factors beyond inflation can exert control on TIPS returns.

How does this compare to stocks, which are supposed to be a relatively poor inflation hedge?  Here are the same two plots but showing U.S. stock returns instead of TIPS.

Although the relationship between inflation and U.S. stock returns over the last 21 years is also weak, it’s surprisingly better than TIPS.  Again, the long-term history of poor correlation between stocks and inflation still leaves room for extended periods where stocks perform well during episodes of rising inflation.

Inflation Hedging Beauty Contest

I could present a series of cross plots for every asset, but I think you can more clearly compare returns performance relative to inflation changes by ranking the various assets by nominal returns performance in the 7 years with rising inflation and then weighting those ranks by the amount of inflation change in those years.  Such a ranking contest gives the highest score to the asset with the best relative performance in years with the highest positive inflation changes.  Here’s a graph of those results.

TIPS stand out with the best inflation-hedging score among all types of bonds.  But interestingly, the inflation-hedging of TIPS was outscored by all types of stocks as well as real estate (REITs), which won the contest.  And the reputation of gold as one of the best inflation-hedges (the best of a bad lot) is not supported by the last 21 years of returns data.

Portfolios with TIPS

Of course, inflation doesn’t necessarily rise every year, so the above scores focus on one specific type of inflation environment.  Despite TIPS producing underwhelming returns in 2021 and middle-of-the-pack returns in years with more moderately rising inflation, mindful investors don’t care about asset performance under a single inflation condition.  What matters is the long-term sequential performance of assets, or portfolios composed of several assets, across a range of economic and market conditions.

So, as a final assessment of TIPS, I compared the performance of various portfolios since 2001 (the start of the Portfolio Visualizer TIPS data).  This table shows some performance and risk (volatility) statistics for various portfolios over this period.

Portfolio	Annualized Return (CAGR)	Volatility (St. Dev.)	Return/Risk Ratio	Max Drawdown
100% U.S. Stocks	8.17%	15.39%	0.53	-50.89%
60% Stocks/40% 10 Yr T-Bond	7.34%	8.36%	0.88	-26.40%
60% Stocks/40% TIPS	7.39%	9.43%	0.78	-32.86%
60% Stocks/20% TIPS/20% 10 Yr T-Bond	7.38%	8.83%	0.84	-29.58%
60% Stocks/40% REIT	9.21%	16.04%	0.57	-57.00%
60% Stocks /20% REIT/20% Gold	9.35%	12.93%	0.72	-42.83%

A portfolio of 60% stocks and 40% TIPS performed very similarly to a conventional 60/40 T-Bond portfolio as well as a portfolio of 60% stocks, 20% TIPS, and 20% T-Bonds.  This makes sense given that, excepting 2021, this was a period of pretty sedate inflation.  When inflation is tame, TIPS and T-Bonds appear to be essentially interchangeable for the ballast function in a mixed portfolio.

If you want to use other assets for inflation-hedging, the academic research suggests that real estate and gold would be the best candidates.  In this period, a mixed portfolio with 40% real estate performed better than a 100% stock portfolio, albeit with higher volatility.  And a portfolio of stocks, real estate, and gold arguably performed best because it achieved the highest returns, relatively low volatility, and a decent return/risk ratio.

Conclusions

At one time I was pretty excited by the explicit inflation-hedging available through TIPS.  And years ago I concluded that TIPs were a good candidate for the intermediate-term bucket in a three-bucket investing plan.  Perhaps naively, I thought that if inflation ever reared its ugly head, the obvious benefits of TIPS would become readily apparent.

So, when 2021 produced an extremely unexpected and steep rise in inflation, I thought the day had finally come to remove my doubts about TIPS.  Instead, 2021 just clouded the TIPS picture.  Compared to last year, TIPS produced far better returns in 2002, 2007, 2009, 2011, and 2020, despite all those years having substantially lower inflation.

On the other hand, if I ever wade back into the world of bonds², I think the history of TIPS data show that TIPS are often a better choice than conventional Treasury Bonds.  Over the past two decades or so, TIPS have provided similar mixed portfolio performance as T-Bonds during times of tame inflation.  And over the same period, TIPS have generally performed better than T-Bonds in specific years with rising or relatively high inflation.

Unfortunately, if inflation starts to subside to its prior average of around 2%, then this might be the exact worst time to jump into TIPS.  Of the four years that TIPS produced nominal negative returns, they all occurred in years when inflation was decreasing.  The same is not true for the conventional 10-Year T-Bond.  For that reason, I will probably stick with my all-stock investing approach and continue to just observe TIPS from the sidelines.

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1 – I should note that TIPS data from Portfolio Visualizer comes from the performance of the Vanguard Inflation-Protected Security Fund (VIPSX), which is reasonable given that funds are one of the easiest ways to invest in TIPS.  VIPSX came out in 2001, while TIPS first came out in 1997.  So, by using these data, I’m omitting the first four years that TIPS existed.

2 – I have been using cash instead of bonds for my retirement bucket-investing plan for reasons I explain here.  However, I have nearly depleted my cash bucket.  So, my current portfolio is now nearly 100% stocks, assuming we don’t count my main residence as a real estate asset.