In the previous post I highlighted the negative performance (approximately -10%) that has characterized the Inflation Linked Bond category in the last 6 months, represented by an ETF that invests in US Treasury bonds linked to inflation (US TIPS). This result took most investors by surprise probably because they had very different expectations on the potential return of the category in a phase like the one we are experiencing. This was probably fueled by the strong correlation (R2 @ 96) of the ETF (US TIPS) with the reversed trend of real rates. Buying Inflation Linked Bonds means going long real rates: you earn when real rates go down and lose when real rates go up. Let’s try to understand what happened.

What has characterized the financial markets in the last six months has been the sharp rise in nominal rates on government bonds. In particular, if we take the nominal yield of the 10y US TSY and divide it into its two components, today we have:

10y US TSY Nom Yield (+ 3.05%) = US 10y Real Rate (+ 0.3%) + 10y US Inflation Breakeven (+ 2.75%)

The nominal rate is equal to the sum of market expectations for real rates and expectations for the inflation rate. If we take the period used for the analysis of the US TIPS, we note that the breakeven has varied by about + 25bps to + 2.75%; while the real rate went from around – 100bps to + 30bps (+ 130bps).

But why the approximately -10% loss for US TIPS ETFs? Because the effective duration (the sensitivity of the change in the price of an inflation-linked bond to the change in the real interest rate) of the ETF in question is about 7.5. Therefore, approximating we have -7.5 x +1.3 (+ 130bps) = approximately -10%.

What is evident? When you buy TIPS, you are buying real rates with a duration equal to the TIPS you have in your portfolio. In retrospect, what should we have done if, six months ago, we had imagined a risk of market rate hikes (real or breakeven)?

If we had been afraid of a real rate hike we would have had to sell the TIPS in our portfolio or, if we hadn’t had them, we would not have had to buy them.


If, on the other hand, we had been afraid of a rise in breakevens, having the TIPS in the portfolio (not wanting to sell them, because we were convinced that they would have performed well in the current scenario) we would have had to add a short on nominal rates with same duration.

The synthetic position would have been a proxy of short breakeven (= + US TIPS + Short US Nom. Rate = + (Real Rate) + (- Real Rate) + (- breakeven) = – Breakeven)

I propose below an ETF (INFU IM) that has adopted this type of strategy (long TIPS + Short US Nom. Rates = – breakeven) and compare it with the US 10y breakeven.

The two series have a good correlation (R2 @ 70). the ETF performs better (about + 8%) probably due to the good contribution of the short rate to which is added that of the breakeven (as can be seen from the chart).

US Synthetic Breakeven ETF & US Real Rates