TIPs to Protect Yourself from Future Inflation

This article is another in my series about common mistakes that the average individual investor makes in his or her overall portfolio allocation. For these articles, I drew from the 20 years of experience I had at Charles Schwab in dealing with clients face-to-face and helping them meet their financial goals.

In previous articles, I wrote about two areas which were dramatically under-represented in most clients portfolios – commodities and international securities. There is a third area which I found to also be under-represented and that is fixed income investments. Many clients had little or no exposure to fixed income investments.

The most difficult task I believe for allocating funds to fixed income investments is to choose what type of bonds an investor should buy from the myriad of choices available. Obviously, an investor's specific financial circumstances will dictate the final choices. In this article, I will choose an area of the fixed income world that I believe most investors should currently allocate funds toward.

TREASURY MARKET FANTASY

Right now the Treasury market is enjoying it's own titillating little fantasy. It is the ultimate dream of everyone in the bond world. It is nirvana for bond market junkies. It is the D-word – deflation.

The media and financial authorities have fallen in love with the word deflation. The dim bulbs that appear on CNBC air are constantly talking about deflation. This fact alone sets off alarm bells in my head. When is the last time that the conventional wisdom as presented on CNBC ever came true? In fact, when was the first time?

I believe that all of this deflation talk is simply a way for the financial authorities to prepare the public for incredibly massive government spending over the next several years. It simply helps to justify even more massive government bailouts and spending programs. Look at the amount already spent on the “bailout” - nearly $8 trillion. I fully expect that figure to rise by tenfold or more.

I notice that CNBC conveniently seems to have forgotten about how the Treasury market crazies got it wrong in 2003. There was a huge deflation scare at that time too, although on a smaller scale than the current nuttiness. What followed that deflation scare? One of the most massive upward moves in history of the price of many commodities.

Right now, the Treasury market crazies have priced in massive deflation that will occur in the United States for the next decade or longer. They have also priced in corporate default rates of 21%! And this is in the face of massive printing of money and multi-trillion dollar annual deficits.

There is a major headwind that the Treasury market crazies will soon be facing. Over the next four years, 66% of America's current $5.2 trillion of debt has to be rolled over. Who is going to buy all of this Monopoly paper?

Wall Street is expecting the suckers (foreigners) to buy it all. They seem to have forgotten that, thanks to Wall Street, these foreigners have major financial problems of their own. I strongly believe that most foreign investors' funds will be spent in their home markets, buying their own bonds, and funding their own governments' fiscal needs.

When this happens, the Federal Reserve will have to resort to cranking up the printing press to warp speed so that there is enough Monopoly money available to purchase the massive amount of Treasuries which will be issued. Can you say inflation?

MIS-PRICED ASSET - TIPS

In all of the Treasury market nuttiness, there are Treasury securities which have been completely mis-priced. These securities are Treasury Inflation Protected Securities or TIPS. The interest and principal on these securities are indexed to the U.S. Consumer Price Index or CPI.

TIPS have become mis-priced because liquidity has fled the TIPS market, just as liquidity has fled from the equity markets. After all, why would anyone want to own TIPS when everyone “knows” that deflation is here to stay and inflation is dead forever, right?

Wrong! For reasons stated earlier, I believe we will see a mass conflagration of the funds that are currently rushing into Treasury securities at zero or one per cent because of liquidity concerns. And once again, we will see that the conventional Wall Street wisdom will be proven incorrect.

I don't believe we will ever see massive deflation in this country. I believe that the only possibility of deflation in the US would be if we truly see 1930s conditions – where the US GDP collapsed by 50% in nominal terms and unemployment rates were at 25% and corporate defaults were in the 15% range. Sorry, that scenario is not in the cards. What is much more likely is a return of inflation.

TIPS ETFS

An investor can buy an individual TIPS bond, but with the current lack of liquidity the spread between the bid and asked of such securities is unusually large. A better choice may be an ETF which invests in TIPS securities.

Currently, investors have two choices for TIPS ETFs. They are SPDR Barclays Capital TIPS ETF with the symbol IPE and the iShares Lehman TIPS Bond Fund with the symbol TIP.

Both ETFs have many similarities – both ETFs have very low expense fees, both ETFs are down between 7% and 8% for the year, and both ETFs also have a similar average duration of the TIPS bonds that they hold of approximately 7 ½ years.

The only difference seems to be that TIP trades with a higher daily average volume than does IPE and is therefore a bit more of a liquid security.

Due to the current mis-pricing I believe is occurring in the US Treasury market, both TIP and IPE are currently yielding in the 8% range. Keep in mind – this is an 8% yield that investors are receiving on a US Treasury security!

Investors are urged to jump on the bargains occurring currently with regard to the TIPS market. I believe that an immediate purchase of either IPE or TIP will be a wise choice.

Comments

[Rory Litwin:]

Any comment on Western Asset Inflation Management Fund (IMF)? The primary difference, if I'm not mistaken, is that it is not limited to US instruments but also uses inflation-linked securities from other governments, and maybe some other things. It is yielding slightly less. I think it might be good in the event of a falling dollar relative to other currencies, in addition to overall inflation protection. And I am wondering about the tax questions. TIPS are federal tax free, so my preference would be to have them outside of my retirement account. I am guessing that IMF is not tax-exempt.

Comments?

2008 Dec 05 10:46 AM

[mwswi:]

Thanks for your timely article. I've been considering adding TIPS to a tax-deferred retirement account (to constitute approximately 10% of my wife's and my overall bond holdings). And as you point out, now may be a very opportune time to do so with both ETFs being down between 7% and 8% for the year while yielding near 8%. In the mutual fund realm, Vanguard's Inflation-Protected Securities (VIPSX) is currently down 7.7% for the year and yields 6.48%.

2008 Dec 05 12:11 PM

[mwswi:]

Rory,

According to Morningstar's columnist Sue Stevens and what I've been told by other investment analysts/advisors, Treasury Inflation-Protected Securities (TIPS) have a fixed interest rate, but investors’ principal adjusts along with inflation rates. Because interest paid from TIPS is taxable, it’s generally best to hold them in tax-deferred accounts.

Naturally, there's exceptions to every rule, but this is the guideline that I've been following. I'd be very interested in learning if the investment landscape has changed in this respect...

2008 Dec 05 12:22 PM

[KevinT:]

The other very good reason for holding TIPS is that they are an asset classes (using the term somewhat loosely) which is negatively correlated with almost all the other asset classes. If you look at the asset correlation matrix at www.assetcorrelation.c... you will notice the benefit of holding TIPS: protection against inflation and negative correlation with most other asset classes.

2008 Dec 05 05:35 PM

[mangy cat:]

on same line of thinking as tony and rory, i.e. weaker greenback, why not go international with wip?

2008 Dec 05 07:33 PM

[Extreme Val...:]

This question may seem elementary but the current yields everyone speaks of are difficult to confirm. I looked at the charts of IPE and TIP and it appers both ETF's stopped paying dividends. Per MSFT Investor, IPE's last dividend was 2/08 and TIP stopped it's regular monthly dividend in November. Thoughts?

2008 Dec 06 04:52 AM

[AlexR:]

Not sure about IPE, but TIP suspended its dividend when the underlying bonds stopped gaining principal value. Their 8% yield was not funded from interest payments, but from CPI adjustments on the principal, which they monetized by selling bonds.

On Dec 06 04:52 AM Extreme Value Investor wrote:

> This question may seem elementary but the current yields everyone
> speaks of are difficult to confirm. I looked at the charts of IPE
> and TIP and it appers both ETF's stopped paying dividends. Per MSFT
> Investor, IPE's last dividend was 2/08 and TIP stopped it's regular
> monthly dividend in November. Thoughts?

2008 Dec 06 12:44 PM

[Tom B:]

Is this also a problem for TLT, the non-inflation adjusted bond ETF?


On Dec 05 12:22 PM mwswi wrote:

> Rory,
>
> According to Morningstar's columnist Sue Stevens and what
I've
> been told by other investment analysts/advisors, Treasury
Inflation-Protected
> Securities (TIPS) have a fixed interest rate, but
investors’
> principal adjusts along with inflation rates. Because
interest
> paid from TIPS is taxable, it’s generally best to hold them in
tax-deferred
> accounts.
>
> Naturally, there's exceptions to every
rule,
> but this is the guideline that I've been following. I'd be very
interested
> in learning if the investment landscape has changed in this
respect...

2008 Dec 06 01:41 PM

[fatpitch2:]

Like other bonds the nominal return on TIPs (the part not connected to inflation) has been dropping. Take a look here: www.treasurydirect.gov...

For example it appears the last 5-yr note auction offers only 2%.

Yes, the TIP is inflation adjusted, but since the adjustment factor is based on the CPI which, at least I think, understates inflation you may not be doing all that well. That is to say that a 2% nominal return with a CPI adjustment that does not really make you "whole" from an inflation standpoint may not look so hot if inflation rates start rising....

Comments?

I do currently hold the Vanguard TIP fund in my 401k to keep the taxes simple, but I am starting to question myself on this.......

2008 Dec 06 04:54 PM

[notsosmart:]

anything based on our govt. figures is a bad bet

2008 Dec 06 08:36 PM

[annette:]

are tips paying 8% or not. simple answer, please.

if I invest $10,000 in tips for one year, do I receive $800 for the year?

anyone, I need your help.

2008 Dec 06 09:01 PM

[granger:]

Great article, I enjoyed it, thank you

2008 Dec 07 10:35 AM

[fatpitch2:]

Annette:

The simple answer to your question is "no" if you went into the market right now and bought some TIPS you most likely NOT get 8% annually, and the returns WILL most certainly fluctuate.

TIPS have a coupon rate (nominal interest payment made) and then
TIPS bonds' principal is linked to changes in the Consumer Price Index (up or down) and can provide an effective hedge against inflation in an investor's portfolio relative to standard Treasury bonds. As CPI rises, the principal in the individual TIPS bonds is adjusted upwards. The nominal/coupon interest on the bond is then paid on the higher principal, which raises the overall effective yield of the security.

Also, note that inflation is just one component of interest rates and that changes in the "real rate" or the risk free cost of capital will cause the value of TIPS bonds to oscillate up or down just like Treasury bonds. It is also important to note that because of the inflation adjustment on TIPS, the yield you get today is not set in stone and investors should be prepared for it to move up or down depending on the movements of the CPI.

It is more complicated than it appears at first glance.... but there are many good articles explaining how the work ... far better than I can do here...

2008 Dec 07 02:48 PM