The Hard Truth About TIPS

The bad news is that this premium may not be much higher than the premium investors get for accepting inflation risk. And since risk is real, you've just layered on another slice of future spending volatility that a client must be willing to accept.

Too many advisors view the credit risk premium as just a bonus that smart investors get for avoiding Treasurys. Swedroe points out that the actual performance difference between long-term government and long-term corporate bonds is "basically zero or negative after fund fees." 

Reaching for yield by increasing credit risk can seem like a better way to energize bond returns.  Swedroe notes that "today, the Vanguard high-yield fund (which isn't junk) has about a 3.5% yield with a four-year duration." But this extra yield comes at a cost of both higher volatility and higher correlations with risky assets.

"You're taking significant credit risk, and when COVID happened that fund got crushed," he explains. "The main purpose of fixed income should be to dampen the risk of a portfolio to an acceptable level. In 2008, junk bonds dropped by half. How do you rebalance your portfolio? The same thing happened in COVID — you have to look at correlations. Correlations are average and correlations drift."

Blanchett agrees that "while high-yield bonds can be attractive to some investors, they are incredibly risky as 'bond' investments go, and have correlations with the market that actually increase (versus decrease) during down markets, which is the opposite [of what] you want from a diversifier asset class like fixed income."

In fact, high-yield bonds have historically had about a 0.60 correlation coefficient with U.S. equities, while Treasurys have had a correlation near zero. Practically, this means that an advisor can construct a portfolio using Treasurys that offers a higher expected return for the same amount of risk by increasing the allocation to stocks.

Although counterintuitive, the improved diversification value of Treasurys can help an advisor increase allocation to risky assets and achieve a more efficient portfolio. Theoretically, since TIPS reduce spending risk even more, an advisor can take even more risk with TIPS.

The Search for Fixed Income Returns

The flood of liquidity has left many investors with few attractive options. Fixed income investors are stuck with negative real returns for short maturity bonds, and only a modest premium for long-term bonds. S&P 500 valuations as a percentage of trailing 10-year profits are higher than at any point in U.S. history other than the tail end of the tech bubble (after which 10-year S&P returns were negative).

According to Bianco Research, U.S. households hold $3.5 trillion in checkable deposits — up from just $800 billion in the third quarter of 2019. There are record amounts of cash on the sidelines sitting in accounts that will lose at least 5% of purchasing power in 2021 waiting for something appealing to turn up. 

The European Central Bank recently warned that the risk of inflation would punish a range of leveraged investments that could fall sharply in value of interest rates rose in tandem. While Western economies are once again heating up post-pandemic, the ECB warned of "pockets of exuberance in credit, asset and housing market as well as higher debt levels in the corporate and public sectors."

Easy borrowing at low rates to leverage purchases of assets such as real estate may seem safe, but could lose value quickly if interest rates rise. The ECB also warned that "more exotic segments, such as crypto asset markets, also remain subject to speculative bouts of volatility." 

Investors who have tried to reach for yield by increasing credit risk face the possible double whammy of rising interest rates and the deterioration of credit markets during a flight to safety.

Another Option

Rather than hoping to juice returns through a credit risk premium, Swedroe suggests considering the capture of a premium through illiquid private equity investments such as interval funds.

Interval funds do not provide immediate liquidity to investors hoping to sell shares back to the fund company, but occasionally offer investors the opportunity to redeem shares to capture investment returns. These funds seek investments in highly illiquid, income-producing assets that offer higher yields than publicly traded fixed income investments.

According to Swedroe, "any private asset has a big illiquidity premium" because "most people want liquidity and they pay a lot to get it. Wealthy investors can take advantage of an illiquidity premium. Most people are not familiar with the asset class."

Although Swedroe encourages many clients to invest in interval funds because "their Sharpe ratios are much higher" than those of comparable liquid investments, he cautions that "you're dealing with unrated securities. You've really got to trust the manager." 

Recent research on the excess performance of private equity over publicly traded investments on the aggregate is mixed, however. A pair of articles (article 1, article 2) published in 2020 in the Journal of Investing found little evidence that private equity investment performance has been higher than publicly traded investment performance in recent decades. 

The hard truth about TIPS is that they offer returns that are unattractive. But they may be more attractive than the alternative of accepting greater risk in an inflated market where the reward for taking risk is so small. 

Advisors need to ask themselves whether greater investment risk to capture these premiums is truly in the client's best interest, or whether by taking risk they are merely seeking the comfort of uncertainty to avoid the depressing reality offered by risk-free investments today.