US TIPS for a Singaporean investor?

Treasury inflation-protected securities (TIPS), are bonds introduced by the US government where the principal (amount you loan) rises or falls with inflation. Many developed countries also offer inflation-protected securities, for brevity I will just call them TIPS too. TIPS are a popular and useful investment tool to protect against unexpected inflation. They are especially useful for retirees, whose primary concern is to maintain their spending power throughout retirement.

The Singapore government currently does not issue TIPS, likely because of a lack of investor demand coupled with many investors not understanding these securities. You can read the MAS full statement here.

Since the Singapore government does not issue TIPS, this short post explores whether it makes sense for a Singaporean to hold TIPS issued by the US or other developed countries. First, a quick recap on bonds:

• Bond: An asset that represents a loan made by a borrower from an investor

When you purchase a bond, you are essentially loaning money to the bond issuer. The amount you lend is called the principal. You will also receive interest on your principal—exactly like how you need to pay interest for a mortgage loan. A bond’s maturity date is basically how long the loan lasts. When a bond matures you get back the principal.

TIPS are unique in that the principal is tied to some measure of inflation, like the Consumer Price Index (CPI). As inflation rises, your principal amount will also rise. If inflation falls (or deflation occurs), it will also fall. When TIPS mature, you get back your original principal or the inflation-adjusted principal, whichever is higher. Let’s run through an example. To keep things simple, we just buy $10,000 of TIPS that mature in 3 years, and we don’t reinvest the interest earned:

Year	Inflation that year	Principal	2% interest per annum (nominal)
0	–	$10,000	–
1	0%	$10,000	$200
2	5%	$10,500	$210
3	-10%	$9,450	$189

At maturity, you still get your back $10,000 even though deflation resulted in your inflation-adjusted principal falling to $9,450. Notice that while the interest remained at 2%, the interest you get on the inflation-adjusted principal actually changes according with inflation. When inflation went up 5%, your interest received increased by 5%. And when there was deflation of 10%, your interest received decreased by 10%.

Let’s contrast the same scenario, invested in a nominal (not inflation-protected) bond:

Year	Inflation that year	Principal	2% interest per annum (nominal)
0	–	$10,000	–
1	0%	$10,000	$200
2	5%	$10,000	$200
3	-10%	$10,000	$200

So in this scenario, our nominal bonds earned $200 x 3 = $600, while our TIPS earned $200 + $210 + $189 = $599. In this scenario, inflation over the 3 years was negative—it was a deflationary period. Typically, when inflation is lower than expected, TIPS have lower returns compared to nominal bonds. The reverse is true, when inflation is higher than expected, TIPS have higher returns. This shouldn’t be surprising, since the principal value of TIPS adjust according to inflation.

TIPS thus act as they are supposed to—a hedge against unexpected inflation. This makes a lot of sense for an investor that cares about retaining his purchasing power: If inflation is higher than expected, your TIPS return more and so retains your spending power. If instead inflation is lower than expected, your spending power isn’t affected as much since prices increased less than expected. In both cases, a safe bet for the TIPS investor.

Sounds great, but there’s no TIPS here!

Well, the good news is that buying US TIPS can make sense. This might seem surprising. After all, US TIPS are bought in USD, and protect against US inflation. Why should we care as a Singaporean investor spending in SGD?

To see why, let’s work through the possible scenarios that could happen.

Scenario 1: Singapore inflation is higher relative to US

Suppose MAS says inflation for the next 5 years would be 2% per year, but in actual fact for the next 5 years inflation would actually be 5%. Let’s assume that this unexpected inflation doesn’t hit US. If this is the case, your US TIPS will return a similar amount to nominal US bonds, with inflation not seeing a significant impact there.

However, since there was high inflation in Singapore relative to the US, the SGD will also be weaker relative to the USD. An intuitive way to understand this, is to see inflation as a decline in the value of money. Since the SGD saw higher inflation relative to the USD, the value of SGD relative to the USD decreased.

This means the returns you got from your US TIPS, denominated in USD, can be exchanged for more SGD, maintaining your spending power! Even though your bond yield didn’t adjust for inflation, the exchange rate between SGD and USD did. The TIPS still did their job protecting you from unexpected inflation.

Scenario 2: US inflation is higher relative to Singapore

Let’s flip the scenario. US is hit with unexpectedly high inflation, while Singapore remains stable. Since US has high inflation, the principal of your TIPS are adjusted accordingly. This time the exchange rate works against you, since the USD becomes weaker relative to the SGD. But since the TIPS adjusted for inflation, you have more returns—you aren’t punished for holding US TIPS.

Scenario 3: Both US and Singapore are hit with high inflation

Now this case should be easy to work through. If both countries are hit by high inflation, the exchange rate would stay similar since neither became weaker relative to the other. At the same time, you would get higher returns from the US TIPS since they were hit by high inflation.

Bottom line

The 3 scenarios covered all the possibilities of high inflation affecting you. In all of the scenarios, investing in US TIPS provided protection from unexpected rise in inflation to the Singapore investor spending in SGD.

A natural follow-up is to wonder what happens when there isn’t high inflation? What if there was lower than expected inflation, or deflation instead? The bottom line is that when inflation moves differently between the two countries, there will be an opposing force from the exchange rate making up this difference. If both experience low or negative inflation, TIPS will perform worse than nominal bonds. But in that case, your spending power is also not eroded since high inflation did not occur. If your goal is to protect against inflation and not to outperform nominal bonds, then TIPS would do that for you.

So US TIPS can make sense. But note that while they still can protect you from inflation, you are still left with currency risk or exchange-rate risk. This is the risk of price fluctuation between USD and SGD. Unfortunately this isn’t a risk we can get rid of unless we buy TIPS in SGD. However, in relatively stable economies this risk isn’t too high, and arguably getting protection against inflation is more important than eliminating currency risk.

Some misunderstanding about TIPS

There are a few things that are said against TIPS, most of which, while true doesn’t really make sense as an argument against TIPS.

TIPS can have lower yields than other bonds.

This obviously depends on which bonds you are comparing TIPS to. If you compare a government-backed security with corporate bonds, the yield is obviously higher for corporate bonds since the risk is higher.

If you compare TIPS with government treasuries of similar duration, the expected real returns should be similar. This is because expected inflation is priced into bonds. It is unexpected inflation that account for the difference in actual TIPS vs nominal treasury yields.

There is a caveat: when buying TIPS you could be seen as “paying” for the inflation hedge. If everyone flocks towards TIPS during periods of high inflation, the cost of this hedge would obviously increase, resulting in lower expected returns. The reverse is true, where in situations where nobody cares about being protected from inflation, the cost of the hedge will be cheaper. This may be what Singapore is experiencing today.

TIPS are a bad choice during deflation

This is basically a tautology. TIPS are meant to protect against inflation, obviously it would be worse off if inflation is lower than expected. But if I knew ahead of time that inflation would be lower than expected, I would be a prophet, and also a millionaire.

TIPS can have negative returns

Applies to any investment really. That’s why investments are risky.

How to buy TIPS?

There are two main ways to buy US TIPS. You can buy it from a broker (like IBKR), and buy a single bond being traded on the secondary market. Alternatively you can buy a bond fund. ETF providers like iShares and State Street (SPDR) offer funds that buy a basket of TIPS. There are also funds offering TIPS from developed countries, not just US. There aren’t too many options for Ireland-domiciled funds, but you can check them out here. Both ways of buying can make sense, and come with their own pros and cons.

Thanks for reading, I hope you learnt something interesting about TIPS from this short post.