Inflation is a perennial concern for investors navigating an ever-changing economic landscape. According to a recent BlackRock report, inflation ranks as the top macro concern among firms representing an aggregate $23 trillion in assets under management, with international trade tensions poised to potentially exacerbate price pressures in the coming year.

For investors seeking to preserve purchasing power, Treasury Inflation-Protected Securities (TIPS) may be a valuable tool. TIPS are U.S. government bonds designed to hedge against inflation by adjusting both principal and interest payments based on changes in the Consumer Price Index (CPI), the widely accepted measure of inflation in the U.S. At maturity, investors receive the greater of the inflation-adjusted principal or the original amount invested — a feature known as the deflation floor.

In this article, we examine the use cases for including TIPS in a portfolio and explore the virtues of short duration TIPS (short TIPS or short-term TIPS), which boast specific qualities that may make them suited to perform in high inflation environments. We also analyze the hedging properties of short-term TIPS in the context of “inflation surprise” — where realized inflation differs from expected inflation — with short TIPS providing potential protection against price shocks.

A common misconception is that TIPS provide returns equal to inflation plus a stated percentage. However, the reality can be quite different. Many investors learned this the hard way in 2022, when TIPS saw negative total returns as a sharp rise in U.S. interest rates offset the increase to their value from high inflation. That year the ICE BofA 10+ Year US Inflation-Linked Treasury Index (G9QI), which tracks long-term TIPS, posted a total return of -31.35%, as shown in Figure 1.

Issued with maturities of 5, 10, or 30 years, TIPS carry duration risk like other fixed-rate bonds. Duration measures a bond’s sensitivity to changes in interest rates and is defined as the percentage change in a bond’s price given a one percentage point change in yield. This means bonds (including TIPS) are vulnerable to losing value during periods of rising interest rates.

This is not to say there isn’t a place for longer duration TIPS in a portfolio: an investor who expects interest rates to drop may see strong performance by buying longer duration TIPS, such as in 2020 when the G9QI index saw a +24.91% return. Nevertheless, during periods of both high inflation and a rising yield curve — which is not unusual — the price impact of rising interest rates can outweigh the positive impact from higher inflation, resulting in negative returns on longer term TIPS. While the deflation floor mitigates this risk for investors who hold to maturity, the mark-to-market losses for investors in the interim can be substantial. Shorter maturity bonds, however, have lower duration (are less sensitive to interest rates) with fewer future cash flows at risk.

Short-term TIPS — those with maturities less than one year — demonstrate strong alignment with realized inflation, as evidenced by their correlation with CPI changes. This means they may be useful for providing near-term inflation protection.1

The ICE U.S. Treasury 0-1 Year Inflation-Linked Bond Index (ICETIP1) tracks TIPS with less than one year but more than one month remaining to maturity. If duration is reduced by shortening maturity, historical results reveal a correlation between CPI changes and ICETIP1 returns, as shown in Figure 2.

Expected vs. unexpected inflation

Understanding the distinction between expected and unexpected inflation is crucial for portfolio construction but is often overlooked. In short, “expected inflation” is what the market has priced in, whereas “unexpected inflation” is essentially the risk the market is wrong. When an investor buys TIPS at a given point in time, the price reflects the market perception of expected inflation.

A market-implied measure of expected inflation can be calculated as the difference between the nominal yield on U.S. Treasury securities and the real yield on duration-matched TIPS. In other words, subtracting the yield on 10-year TIPS from the yield on 10-year Treasuries can provide a rough view of the market’s expectations of inflation over the next decade. There are many other subtle dynamics at play — such as maturity mismatches, as well as differences in supply-demand and liquidity — but this implied “breakeven inflation” yield difference is generally used as a market-implied measure of expected inflation.

Using the ICE BofA 0-1 Year US Treasury Index (G0QA) as the nominal yield benchmark and ICETIP1 as the real yield benchmark, we can determine market-implied expected inflation. A 12-month rolling average smooths out short-term market volatility to reveal the underlying trend.

As Figure 3 demonstrates, however, expected inflation can significantly diverge from realized inflation (as expressed by the change in the CPI).

Inflation surprise and TIPS performance

Inflation surprise — the difference between realized inflation and the previous period's expected inflation rate — is where short TIPS may demonstrate their value proposition.

Figure 4 provides a visual representation of inflation surprise, as rolling 12-month expected inflation is overlaid with the realized inflation print of the CPI, and the spread between the expected rate and realized rate is expressed as inflation surprise.

Analysis of 12-month rolling averages reveals that short TIPS have outperformed during periods of unexpected inflation. Figure 5 shows that overlaying short TIPS excess returns — defined as the difference between returns on short TIPS and short nominal securities — with inflation surprise data demonstrates a clear pattern: positive inflation surprises have correlated with total returns for short TIPS.

Investment implications and conclusion

Short TIPS may be a valuable tool for investors seeking to safeguard purchasing power in an uncertain inflationary environment. However, from a portfolio construction perspective, not all TIPS are created equal.

In an environment with relatively high inflation, but in which the longer end of the yield curve is expected to decline, long-maturity TIPS with their increased sensitivity to interest rate movements can be an important part of portfolio strategy. Short TIPS, on the other hand, may be more suited for environments with high near-term inflation and increasing prices. Short TIPS also have shown to correlate with surprise inflation and may provide protection against unexpected price shocks.

By incorporating TIPS thoughtfully into a portfolio — with particular emphasis on shorter maturities — investors may achieve a more resilient strategy that balances inflation hedging with interest rate risk management. In a world where portfolio managers with $23 trillion in assets cite inflation as their primary macro concern, considering inflation protection is particularly relevant.