Try a TIPS Mixer in Your Equities Cocktail

As product manager of the S&P STRIDE Indices, I sometimes find myself extolling the virtues of Treasury Inflation-Protected Securities (TIPS), which I believe are an underappreciated asset class.  When inflation is relatively tame, people often ask why they should think about TIPS.  The answer is that TIPS don’t hedge expected inflation—that’s already priced in.  TIPS hedge unexpected inflation, and we are fortunate, because unexpected inflation is what produces particularly unpleasant circumstances if one’s portfolio does not keep up.

But hedging unexpected inflation is not the only benefit of TIPS.  They also seem to mix well with stocks. Historically, TIPS have exhibited low and sometimes negative correlations with U.S. equities.  Exhibit 1 compares the rolling 36-month correlation of the S&P 500® and the S&P 500 Bond Index (made up of corporate bonds issued by S&P 500 companies) to that of the S&P 500 and the S&P US Treasury TIPS 7-10 Year Index.  The correlation of stock returns to TIPS returns is consistently and significantly lower than the correlation of stock returns to nominal corporate bonds.

Exhibit 1: 36-Month Rolling Correlations

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For the 15-year period ending December 2016, the stocks-bonds correlation of monthly total returns was 0.256, while the stocks-TIPS correlation of monthly total returns was only 0.047.  Because TIPS generally exhibit lower correlations to stocks than do nominal bonds, they may be a better portfolio diversifier.  To examine this possibility, we constructed two hypothetical portfolios, one comprising a 50/50 blend of the S&P 500 with the S&P 500 Bond Index and the other a blend of the S&P 500 with the S&P US Treasury TIPS 7-10 Year Index.

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While past performance is no guarantee of future results, the benefits of lower correlation can be seen in the performance of the indices and hypothetical portfolios over the 15-year period ending December 2016.  Even though the S&P 500 Bond Index offered the best risk-adjusted return on a stand-alone basis, we see that the blend of stocks and TIPS captured most of the upside of the S&P 500 with a fraction of the volatility.  For equity market participants, getting a bit “TIPSy” may not be a bad idea.

The posts on this blog are opinions, not advice. Please read our disclaimers.

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