Are inflation protected bond funds a hedge against rate hikes?

Question

Generally speaking, I'm a buy and hold index fund investor, with a long-term time horizon (20+ years). I currently keep ~12% of my account in intermediate-term bond funds. I don't usually make big money moves other than rebalancing my portfolio once or twice a year. I'm basically never trying to "time the market" or make any kind of swing trades, but looking at the response to the recent Fed interest rate hike got me wondering if I should rebalance my bonds over to something like a TIPS fund, or even put some in a Series-I bond for a while, at least until the current rate-hike cycle chills out.

Does a TIPS mutual fund or ETF (like VTIPS) provide the same principle protection as buying the bonds directly and holding to maturity? Does a move like this make sense if I think we're not done with high inflation just yet?

Maybe I'm overthinking the situation. All told, it probably won't have a large affect on my portfolio, since I'm not looking at retirement for another 20+ years. I honestly have very little understanding about how financial instruments work, which is why I just put money into low-cost index funds at regular intervals, and sit on it.

Answer 1

Inflation protected securities (IPS) protect against inflation, not against interest rate increases. Since rising inflation is often accompanied by interest rate increases, IPS can mitigate the losses from those increases in rates, but interest rates can rise for other reasons, and IPS don't really help you in those cases. In particular, if the central bank is concerned about inflation in the future, it might raise rates proactively, which would cause bonds of all sorts, inflation protected or not, to fall. If such proactive moves were successful in heading off inflation, then the inflation adjustment of the IPS would not have a chance to kick in. In that scenario the IPS would provide no particular protection against rising rates.

There is another complication, which is that IPS generally have a lower nominal yield than regular bonds. The gap is determined by investors' inflation expectations. If investors expect low inflation, the gap will be small (i.e., investors would be unwilling to give up a lot of yield to get an inflation hedge); conversely, if inflation expectations are high, the gap will be larger (i.e., investors are more willing to trade yield for inflation protection). In cases where inflation expectations are changing, this can affect the return on IPS. For example, right now (mid 2022), inflation expectations are probably pretty high, so the nominal yield on IPS should be relatively low. If at some point in the future inflation gets under control, inflation expectations will likely drop, causing nominal IPS yields to rise, and therefore prices to fall, even if interest rates are stable or falling. In other words, if you were to shift your portfolio into IPS whenever you see evidence of inflation and shift back into conventional bonds when you see evidence inflation has subsided, you would probably be buying high and selling low.

This is just a special case of the general principle that you shouldn't tweak your investment portfolio in response to the news. Decide ahead of time what allocation you want for IPS, and incorporate that into your normal rebalancing cycle. IPS can do good work for you, but not as a reaction to inflation stories in the news.

Answer 2

Inflation-protected securities give you a guaranteed real (inflation-adjusted) return over the life of the bond. They do that by adjusting the face value of the bond by some inflation factor like the CPI (Consumer Price Index).

Of course, if inflation ends up being lower than what the market predicts, then you'll have less return on your bonds (but will benefit overall from lower inflation).

So they are a hedge against inflation, not necessarily interest rate hikes (they are correlated but not 100%)

I can't speak to the effectiveness of VTIPS, but given that I don't see a price spike in the last month when CPI numbers were higher than in prior years, I don't know that it is an effective hedge against inflation or interest rates.