TIPS real yields hit 3% as inflation-protected bonds offer rare upside

Thirty-year TIPS real yields hit 3%, the highest since their launch 16 years ago, as inflation-protected bonds offer rare upside in today's market.

"Long TIPS once again yield 3.0% above inflation and, as in 2008, these rates may not last long," said Ed McQuarrie, financial historian at Santa Clara University. "You snooze, you lose. The time to buy TIPS is now."

The 30-year TIPS offers a government-guaranteed real return of 3.0% plus inflation, currently running at 3.4% CPI. After including principal accrual, the bond offers a 6.4% static return, compared with 5.2% for the 30-year nominal Treasury. The 10-year TIPS yields 2.35% real, while the 5-year yields 2.05%. Break-even inflation — the rate at which TIPS and nominal Treasuries produce equal returns — sits at roughly 2.3%, well below the current 3.4% CPI reading.

If real yields partially revert toward their long-term average of about 1%, a move from 3.0% to 2.0% would produce a 27.5% one-year return on 30-year TIPS. With US gross debt surpassing $40 trillion and net interest payments consuming 3.2% of GDP, investors are increasingly turning to inflation-protected securities as a hedge against fiscal risk.

Real rates, not inflation expectations, are driving long-term bond yields higher today. The break-even rate — the difference between nominal Treasury yields and TIPS yields — has remained anchored around 2.3% since the pandemic, despite CPI running above the Federal Reserve's 2% target for 65 consecutive months. The market believes higher inflation is temporary and the Fed will eventually achieve its inflation objective.

What is driving real yields higher is the demand for capital. Higher government borrowings due to the federal deficit, the trillion-dollar-plus hyperscaler buildout, capital spending pull-forward from tax breaks, and a growing economy have all pushed real rates up. Corporate earnings are booming. If the economy eventually cools, real yields should normalize lower.

TIPS also mitigate several idiosyncratic sources of inflation, including a spike in oil prices, tariffs, dollar devaluation, a possible labor shortage, or financial repression resulting from federal debt and deficits. The principal adjusts based on changes in the Consumer Price Index with a three-month lag, and the coupon is tied to the adjusted principal, so the value of the coupon rises with inflation as well. In the unlikely event of deflation, the original principal acts as a floor.

Fiscal Risk Creates Both Threats and Opportunities

Skeptics of long-duration TIPS point to two risks: financial repression resulting from the national debt problem and opportunity cost. Forty trillion dollars in national debt and annual deficits of 6% to 7% of GDP are an unmitigated problem that Washington isn't addressing today.

Precedent shows developed countries typically use financial repression to reduce overwhelming debt burdens. The United States used financial repression extensively after World War II when debt-to-GDP peaked at 119%, driving real yields deeply negative. If the Fed were to suppress interest rates to keep interest expense under control, TIPS would become a safe haven for their inflation protection, and real yields would turn negative — generating huge profits for long-duration TIPS holders.

Japan offers another precedent. Despite a debt problem far bigger than the US, real rates have remained extremely low for decades. The experience in Japan shows the debt situation could persist for years before meaningful changes occur.

TIPS Outperform Nominal Treasuries

Since 1998, TIPS have outperformed nominal Treasuries by 1.1% per year. Long-duration TIPS offer three sources of return: a historically high 3% real yield, principal accretion tied to CPI currently running at 3.4%, and capital appreciation potential under a mean-reversion scenario typically associated with equities.

The opportunity cost argument — that tying up capital for 30 years at a 3% real yield is uncompetitive with equities — misses the point of owning TIPS. Long-duration TIPS are not meant to replace equities but to provide diversification. They have a very low correlation with equity returns, providing significant diversification benefits. Investors do not need to hold them to maturity but might hold them for a potential mean reversion, then exit. They are highly liquid and can be sold easily.

For investors willing to think in years rather than quarters, long-term TIPS offer a compelling and asymmetric risk-return profile. Jason Zweig, writing in The Wall Street Journal's Intelligent Investor column, said he put a substantial part of his IRA into individual TIPS at real yields of up to 3%, noting that "the closest thing to a risk-free investment" is worth owning when yields are this generous.

This article is for informational purposes only and does not constitute investment advice.