Optimism in US TIPS for Inflation Protection

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Recently, bond yields have experienced a decline as investors speculate that central banks have concluded their hiking cycle. While the accuracy of this assumption remains to be seen, the philosophy of central banks tends to lean towards swift cuts and gradual hikes. The prevailing market sentiment appears to align with this view.

In the context of the asset-allocation strategy, which aims to be robust across various scenarios rather than overly reliant on forecasts, the current environment has limited immediate impact. The focus remains on constructing a portfolio that is well-suited for diverse outcomes. Despite the evolving market dynamics, the 2%-2.5% real yield on inflation-linked bonds continues to present an attractive option compared to conventional bonds.

Inflation-linked bonds, particularly those backed by governments, offer investors a unique advantage by ensuring repayment in a currency that maintains its value, protecting against inflation-induced debasement. While there exists a possibility of political interference in inflation statistics, any such manipulation would likely coincide with severe inflation, further eroding the value of conventional bonds.

The universe of inflation-linked bond exchange-traded funds (ETFs) is somewhat more limited compared to conventional bond ETFs. However, several options are still available. For UK investors, iShares £ Index-Linked Gilts (LSE: INXG) is a viable choice, considering the relevance of liabilities and costs in sterling. Yet, due to structural complexities in the UK linker market, a preference for US Treasury Inflation-Protected Securities (TIPS) is noted.

US TIPS funds offer a range of choices, including broad funds like iShares $ Tips (LSE: ITPS), Lyxor Core US Tips (LSE: TIPG), and SPDR Bloomberg US Tips (LSE: UTIP). Additionally, maturity-specific funds such as iShares $ Tips 0-5 (LSE: TP05) and UBS Bloomberg Tips 10+ (LSE: UBTL) provide alternatives.

While there are euro and global ETFs available, the focus remains on US linkers due to their higher real yields and status as a safe-haven assets. Some ETFs offer currency-hedged options, but in the case of US linkers, an unhedged approach is favored. This is supported by the argument that if UK inflation surpasses US inflation, sterling is likely to depreciate against the dollar over time. As an illustration of this strategy, iShares $ Tips (ITPS) has outperformed its GBP-hedged counterpart (ITPG) over the past five years. In conclusion, the portfolio will maintain a 10% allocation in ITPS.