Definition and Examples of the TIPS Spread
Investors and analysts sometimes use the difference between two assets’ performance to measure something. This difference is known as a “spread” and can indicate different trends depending on what is being compared. The TIPS spread is the yield difference between the 10-year Treasury note and TIPS. The TIPS spread chart below shows the spread going back to 2003. The gray area between the lines demonstrates how the spread has varied over time. During the recession that lasted from 2008 to 2009, you can see that the spread became very small. The spread expanded and then resumed its typical movement as the year progressed. During the COVID-19 pandemic, there was a narrowing of the spread in April 2020. After April, investor expectations for inflation grew as the economy recovered. However, inflation continued to rise, which caused TIPS yields to sink further into negative returns and stay there.
How Do You Calculate the TIPS Spread?
Here’s how it works—in the chart below, you can see the 10-year Treasury note yields in green and TIPS in orange. You subtract the TIPS yield from the 10-year Treasury yield to get the spread, represented by the shaded area in the graph.
How the TIPS Spread Works
By looking at a chart of the spread between U.S. Treasuries and TIPS, you can see how investors’ inflation expectations have changed over time. The chart shows the gap between the 10-year maturity of each note from the beginning of 2003 to the present. The Great Recession began in 2008. The graph shows investor inflation expectations at that time were very low because yields in both investments nearly converged. As the economy recovered in the following years, the spread corresponded with a rebound in global growth and stock prices. The dip in the line during 2010 reflects concerns about the European debt crisis, while the decline in 2011 was caused by the debt ceiling crisis and worries that the U.S. might default on its debt due to its political impasse. TIPS are designed to help prevent investors from losing money on their Treasury holdings due to inflation risk. The principal paid on these securities goes up or down based on changes in the Consumer Price Index, a measure of the rate of inflation in the U.S. Upon maturity, you are paid either the adjusted or original principal, whichever is greater. You might notice that the TIPS yield sometimes dips into negative numbers. Here’s how that works—TIPS are issued and pay interest to maturity. If you bought a TIPS at 2% interest to maturity, but the average inflation rate over the period is 2.5%, your return is -0.5%.
What It Means for Individual Investors
Both Treasury and TIPS yields are subject to market forces and investor emotions. Returns diminish as prices rise—if more investors turn to these investments during economic downturns to preserve capital, prices will rise, and returns will fall. The spread will then indicate inflation expectations at that time and nothing more. Additionally, because the data are a record of past yields, a graph of the spread is backward-looking. It shows how investors felt at the moment the yields were recorded. This backward-looking nature of the spread makes it helpful in gauging how investors and the market felt about inflation during specific periods. However, the spread shouldn’t be used to try and predict inflation because swings in the market, investor sentiments, and economic conditions can affect it.
