As inflation expectations rise, so does the average amount by which TIPS outperform U.S. Treasurys Investors who own TIPS don’t need to worry about how bad inflation may be in the coming months and years. Many worry anyway. Because they do, all TIPS investors — even those who know better — have to worry too.

TIPS — U.S. Treasury Inflation Protected Securities — carry a quoted yield above the U.S. inflation rate. At the most recent TIPS action in April, for example, the Treasury issued five-year TIPS with a real yield of 2.242%. That means investors who bought at auction and will hold until maturity in April 2029 will receive a return of 2.242% annualized above inflation.

That’s why these investors do not need to worry about inflation. Their purchasing power will grow at a 2.242% annualized rate for the next five years regardless of how hot or cold inflation may run along the way.

The reason TIPS’ prices nevertheless fluctuate, sometimes significantly, is that their popularity waxes and wanes. Investors become more interested in TIPS when they worry that inflation is worsening, and vice versa, according to Joseph Kalish, chief global macro strategist at Ned Davis Research. In a recent note to clients, Kalish wrote that “when inflation is rising … investors prefer TIPS over nominal Treasurys and TIPS outperform. Conversely, when inflation expectations recede, investors prefer nominals over TIPS.”

To illustrate Kalish’s point, I correlated inflation expectations with the relative returns of TIPS and nominal Treasurys over the past two decades. For inflation expectations, I relied on a model devised by the Cleveland Federal Reserve, whose inputs include “Treasury yields, inflation data, inflation swaps, and survey-based measures.” To measure the performance of TIPS, I focused on the iShares TIPS Bond ETF TIP. For nominal Treasurys, I chose the iShares 7-10 Treasury Bond ETF IEF, which has an average effective duration similar to the TIP ETF.

The chart below illustrates what I found. Notice that, as expected inflation goes up, so does the average amount by which TIPS outperform nominal Treasurys.

If you trade between different categories of bonds as short-term frequencies, the investment implication of these results would be to favor TIPS over nominals if you think inflation in the coming months will be worse than expected. In contrast, you would favor nominal Treasurys over TIPS if you think inflation will decline more than the consensus.

A different implication applies if you plan to buy and hold TIPS until they mature, but want to strategically plan when to purchase them. You would want to buy after a period in which inflation expectations have significantly receded and are about to turn back up. If the future is like the past, TIPS at that point will be significantly undervalued relative to nominal Treasurys.

Forecasting expected inflation is not easy. But this analysis shows what is needed if you hope to be successful at timing switches between TIPS and nominal Treasurys.

Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at