Despite a recent double-digit decline, TIPS now present an attractive valuation due to a significant rise in real rates. This asset class, with $3.5 trillion in the US, has experienced a significant double-digit decline since the beginning of 2022, despite high inflation. While the inflation-linked component provided a cushion of around 10% over 20 months, the surge in the 10-year real rate from -1.0% to 2.45% over the same period had a pronounced and negative impact on TIPS' total return, resulting in a decline of -15% (chart 1). Now, following the substantial increase in real rates, TIPS investments have reached attractive valuation levels.
A 10-year TIPS now offers a real rate of 2.4%, a level not seen since 2008. This is historically appealing, particularly when adjusted for the size of the Fed's balance sheet (chart 2).
Additionally, TIPS exhibit a lower beta compared to U.S. Treasuries, currently standing at 0.8 (beta duration to nominal bonds). This characteristic is valuable in the context of significant volatility in U.S. interest rates, with the MOVE index still exceeding 100. It also becomes important in the event of global economic deterioration, implying lower real rates. This consideration is increasingly significant as uncertainties surrounding inflation persist, driven by factors such as deglobalisation, supply shocks, increased fiscal spending, and the ongoing transition to renewable energy sources.
Furthermore, long-term breakeven rates, reflecting the market's expectations of long-term inflation, have remained remarkably stable at 2.35% (chart 3), only 5bps higher than at the start of the year, while the 5y5y inflation swap rate in the U.S. has surged to 2.8%. This reflects the market's structural concerns about sustained higher inflation.
This, coupled with the cushion of almost 2.5% in real rates, underscores the compelling nature of TIPS as a vital addition to long-term investment strategy.

TIPS function on a unique mechanism (chart 4) that distinguishes them from traditional bonds. Semi-annual adjustments to the CPI ensure their value remains aligned to real-world economic conditions. In contrast to conventional bonds that pay interest on the original principal, TIPS recalculate their interest payments according to the adjusted principal. Yet, the most remarkable facet of TIPS is their built-in protection against deflation. If, by maturity, the adjusted principal drops below the bond's original value due to prolonged deflation, the U.S. Treasury steps in to ensure investors receive at least their initial investment. This feature effectively shields an investor's capital from economic downturns.

TIPS are often subject to misconceptions that can influence investor decisions. Firstly, some believe they are only suitable for retirees or conservative investors. However, their inflation-protective feature is valuable for investors of all ages and risk profiles, especially in inflationary environments. Another misunderstanding is that TIPS offer absolute protection against all forms of inflation. In reality, TIPS are indexed to the CPI, which may not capture all inflationary pressures, such as asset inflation in stocks or real estate, which isn't fully reflected in the CPI. Additionally, many believe that the interest rate on TIPS adjusts for inflation. While the principal is adjusted, the interest rate remains fixed. However, interest payments vary due to the adjusted principal, leading to the misconception of a fluctuating rate.

To understand TIPS, one must first grasp the concept of real rates. Real rates represent the rate of return on an investment after accounting for inflation. It's the rate that reveals the true purchasing power of your money after considering the effects of inflation. By design, TIPS are closely tied to real rates. Their yield which is often referred to as the "real yield," is essentially the return an investor can expect after inflation adjustments. The dynamics of the financial markets mean that real rates can fluctuate, and, in some cases, the fluctuations are dramatic. A recent example of this was in 2022. 

Since their introduction in 1997, TIPS have etched a prominent space in the fixed income market. Historically, they have demonstrated their resilience during periods 
of heightened inflation, acting as a reliable hedge. Even during the 2008 financial crisis, while they experienced volatility, TIPS rebounded quickly, underscoring their defensive characteristics in diversified portfolios. 

With current real interest rates, TIPS hold strong appeal. Growing consensus among economists and market analysts hints at potential structural changes in inflation dynamics. Factors like global supply chain disruptions, stimulus measures, and robust labour markets suggest the possibility of higher inflation. In such an environment, TIPS' value proposition becomes more pronounced.