Good morning all and a happy Sunday to everyone. It was quite the week for markets with the inauguration of President Trump followed by a slew of executive orders, throwing doubt around many sectors and countries, including our Canadian Dollar. President Trump also signed an executive order requiring “all executive departments and agencies to deliver emergency price relief” to Americans. In effect, he wants to reduce inflation. However, we don’t think the policies being enacted by President Trump will help to lower inflation. In fact we think most of the policies are inflationary.

Last week, the market reacted positively as the Core CPI level in the U.S. came in at 0.2% month over month for December, while the market was anticipating 0.3%. The markets celebrated a lower-than-expected inflation print with the bond market the key outperformer on the day. However, the key indicator was rounded to 1 decimal place. The actual level to two decimal places was 0.248%. Therefore, the U.S. inflation number was only 0.002% from being rounded up and therefore landing in line with expectations!

So, if inflation is not subsiding, what tools are available for investors?

TIPS and Real Return Bonds

In 1997 the U.S. Treasury issued the first Treasury Inflation-Protected Securities (TIPS). These bonds had a very simple premise, to offer bond investors protection from inflation. In Canada we also have a similar market, referred to as Real Return Bonds (RRBs), which the Federal Government began issuing in 1991. A TIPS or RRB is issued with a coupon (much like other forms of debt) but the unique feature is that the face value compounds at the observed levels of inflation.

In Canada, not only have we seen Federal and Provincial issue these bonds but we have also seen infrastructure owners sell these bonds to the market. For example, not long after the opening of the toll road, the operators of the 407-toll route in Ontario, issued real return bonds. This aligns the cashflows of the toll road, increasing with inflation, to the cashflows bondholders receive. Unfortunately for Canadians, the issuance of Federal RRBs was halted in 2022 due to a lack of demand!

The Math

In a simple example, if you were to buy a 10-year TIPS for $1000, then the principal grows each year with the reported level of inflation. Assume after the first year, the realized level of inflation was 3%, then the principal (face value or par) of the bond would now be $1030. The interest payment you receive off that bond would also benefit from the inflation protection as it would be based upon the new principal. If the coupon was 2%, then after 1 year not only would your principal have grown by 3% but your coupon would have grown to $20.60 from $20 (2% of $1030).

Bonds and Inflation

Bond holders tend to be marginal losers in an inflationary environment. In most cases, an increase in inflation means that the purchasing power of the principal and coupon payments of the bonds are decreasing. If the yield offered on the bond is not enough to compensate for the level of inflation, then the bond investors require a greater yield, pushing bond prices down. Bonds tend to react poorly to higher inflationary environments because of this. We have seen this over the last 4 years as a higher inflationary environment have created losses for bonds holders as their purchasing power was eroded. The opposite is true in deflationary environments. In periods where prices for goods and services are declining, bonds tend to perform very well as deferred spending, through saving, increases purchasing power.

TIPS Today

As Treasury bond yields (nominal bonds) have increased, so have the yields on TIPS. TIPS yields are quoted as “real yields” implying that the yield quoted is in excess of inflation. Today the real yield on the 30-year US TIPS is approximately 2.5% (see the chart from below from Trading Economics) which means that buying that bond will deliver the rate of inflation plus 2.5% over the next 30 years. That seems like a reasonable level of reward for the risk and a useful way to protect a portfolio from inflation.

Gold and TIPS

Gold and TIPS have a very interesting relationship. Gold traditionally does best when the real yields available in the fixed income market are low. In essence, gold acts as a better store of value when the returns minus inflation, from the bond market, look less appealing. However, gold has become disconnected, performing well in an increasing real yield environment, as the marginal buyer of the metal is global central banks, looking for ways to reduce their exposure to U.S. Dollars and U.S. Treasury securities.

Holding a combination of gold and TIPS looks like an interesting barbell approach to implement now in a portfolio looking for inflation protection.