A Tip on TIPS

Treasury Inflation Protected Securities (TIPS) are more attractively priced than ordinary Treasuries of the same maturity.

About Ordinary Treasuries

Ordinary Treasuries pay a fixed amount of interest twice per year and mature at a fixed principal amount. Treasury interest for US-persons is exempt from State and local income taxes, but not Federal income taxes. Treasuries can reasonably be held in taxable or tax deferred accounts.

About Treasury Inflation Protected Securities (TIPS)

The principal amount of a TIPS adjusts to increase with inflation or decrease with deflation, as measured by the CPI. However, the maturity value of a TIPS is the original principal amount (”par”) or the adjusted principal, whichever is greater.

TIPS pay interest twice a year, at a fixed rate (not a fixed amount). The fixed rate is applied to the inflation/deflation adjusted principal. Therefore, the interest payments rise with inflation and fall with deflation.

If inflation occurs while you hold TIPS, each interest payment will be higher than the last. If deflation occurs, each interest payment will be lower than the last. At maturity, the principal payment will not be less than par, but could be more than par if net inflation occurred during the life of the bond.

Both the interest earned as well as any increase in principal value on a TIPS are taxable at the Federal level for US-persons. Since the increase in principal value is a non-cash income, TIPS are best held in tax deferred or tax-free accounts.

Inflation/Deflation After 1929 Crash:

There is a debate as to which past bear market is most like the current bear market. In reality each bear and each bull is different — different economies, different regulations, different banking institutions, different political and geopolitical conditions, etc. — but comparisons are inescapable.

If we use the 1929 crash as a model, the post-crash inflation/deflation pattern may be helpful in thinking about TIPS.

The 5-year annualized deflation following the 1929 crash was 4.74%. The 7-year annualized deflation was 2.76%. For 10-years, the annualized deflation was 1.92%. For 20-years to 1949, the annualized change in CPI was an inflation of 1.82%.

A longer-term CPI chart from 1900 to 2005 from a 2006 PIMCO article provides a comprehensive view of CPI changes:

Implied Inflation in Current TIPS Pricing:

By subtracting the yield of a TIPS of a particular maturity from the yield of an ordinary Treasury bond of the same maturity, you obtain the implied annualized inflation over the time to maturity.

The three tables below show the implied inflation for 5, 7, 10 and 20 years as of January 2, July 27, and December 24 of 2008.

You can see that the implied inflation at the beginning of 2008 was positive, and that it rose to a larger positive number by late July. However, now it is implying deflation for 7 years, with a minor return to inflation after 10 years, and low inflation for 20 years.

Our Best Guess on Post-Bear Market CPI Changes:

Because of the massive global, multi-national reflationary government programs, we doubt that the 10 years following this bear market will be as deflationary as the 10 years following 1929. In fact, we are concerned about too much being done too late with consequent post-bear market inflation.

While we may have, or may be about to have, current deflation, it does not seem reasonable to us to project near zero inflation for 7-10 years as seen in current pricing. We also doubt that annualized inflation will be less than 1% over the next 20 years. If those assumptions are correct, then TIPS would seem a better value today than ordinary Treasury bonds.

Relative Pricing TIPS and Ordinary Treasuries:

The following charts plot the ratio of TIP to IEF. TIP is an ETF investing in TIPS, while IEF is an ETF investing in ordinary Treasury bonds.

They aren’t perfectly aligned in duration, as would be the case with individual TIPS and ordinary Treasuries of the same maturity, but the ETF comparison is a reasonable rough match for relative pricing in this discussion.

The average duration of TIP is 5.67 years, while the average duration of IEF is 6.99 years.

You can see by the sharply reduced ratio since mid-2008 that inflation expectations have dramatically reduced.

Plotting the performance of TIP and IEF separately, they look like this:

TIP versus IEF Weekly for 3 Years

TIP versus IEF Daily for 3 Months

Summary:

TIPS are anticipating no inflation for at least 7 years, minimal inflation for 10 years and low inflation for 20 years.

If inflation occurs, TIPS would appreciate in maturity value and increase in semi-annual interest payments.

If deflation occurs, they would have the same par value at maturity as ordinary Treasuries, but the semi-annual yield would decrease in line with the deflation.

Because we believe inflation is at least somewhat more likely than deflation over the next 5-10 years, and certainly over 20 years, we think TIPS are attractively priced now.

If interest rates rise due to a reduction in fear and a move out of Treasuries into riskier assets, but not due to a measured rise in Consumer Price Index, TIPS would decline in market value, as would ordinary Treasuries. However, if interest rates rise due, at least in part, to a rise in CPI, TIPS would increase in interest and market value, while ordinary Treasuries would decline in market value with interest amounts remaining constant.

For these reasons, we think investors with a desire to hold Treasury debt, should hold some TIPS as well as ordinary Treasuries (with TIPS in an IRA or other tax deferred, or tax-free account).

That said, 2+% interest, whether real (TIPS) or nominal (ordinary Treasuries) is not attractive for a large portion of most portfolios.

Comments

[Dr Feelgood:]

Who should we believe: the writer who simply states his opinion on the likely course of inflation, or market participants who stake billions on the outcome? I prefer people who put their money where there mouths are, as opposed to those who simply talk. Last time I talked to my bank manager he told me he liked what I said but he can't credit my account with it.

2008 Dec 31 04:18 AM

[puttster:]

A year ago the "market participants" staked billions that the DJI was worth 13,000. That oil was worth $80... oops, no, $147.. oops we mean $38... How did that work out for you?


On Dec 31 04:18 AM Dr Feelgood wrote:

> Who should we believe: the writer who simply states his opinion on
> the likely course of inflation, or market participants who stake
> billions on the outcome? I prefer people who put their money where
> there mouths are, as opposed to those who simply talk. Last time
> I talked to my bank manager he told me he liked what I said but he
> can't credit my account with it.

2008 Dec 31 09:25 AM

[Fabien Hug:]

TIPS seem to be particularly sensitive to deflation expectations but pretty numb on the upside regarding inflation. I don't like investments which return depends on a gvmt. statistic.

2008 Dec 31 09:38 AM

[Chris B:]

"Full speed ahead and goddamn the inflationary torpedos" is what the treasury and TIP markets are saying. It is an incredibly gutsy call to predict great-depression era net deflation for decades at a time when the government is taking the exact opposite actions that led to the deflation of that era and is instead taking the actions that led to the much less publicized spikes of 10-15% inflation in the 1940s.

Add in the following factors and we seem to have a good case for a massive wipeout of treasury investors in the next couple of years:

1) A massive national debt (thousands of $ per capita) that can only be controlled through dollar devaluation.

2) Government and popular consensus that multi-trillion dollar Keynsian solutions and money supply expansion are the proper approaches and immediate action to implement them, as opposed to the Depression era "liquidationist" approach that sat back waiting for the market and the currency to correct themselves.

3) The possibility that the crash in petroleum and other commodity prices is a temporary futures market blip that has only temporarily suppressed inflation, and that an increased worldwide base of demand will inevitably push these prices, and consumer prices, back up.

I forsee mild and deceptive deflation (1-2% through 2009), followed by a spike or spikes in inflation to 5-15% in 2010-2013 as govt slowly tries to pull back the liquidity they unleased earlier without crushing the recovery. Interest rates will rise, as they can't go much lower, and the Fed will be eager not to pump up another bubble with artificially low rates like they did in 2003-2004. When this happens, those 20 year treasuries bought for 2% yields will have to be repriced to offer the 5-10% yields that current issues will offer. Wipeout.

TIPs investors on the other hand, will have bought in an environment of false deflationary expectations and will sell in an environment of inflationary expectations for massive returns.

If trillions of dollars in treasuries (also being used as collateral) lost 5-10% of their value, would we not have another bank crisis on our hands, similar in magnitude to the crisis that began when returns on mortgage-backed-securi... declined by that amount?

Keep in cash and TIPs for now, and wait for the yields on treasuries and high-quality bonds rise for the next several years before buying in. They're an obvious bubble right now. Check out treaury shorting ETFs if you feel you've forseen too many bubbles without cashing in on them.

2008 Dec 31 10:11 AM

[Emerald:]

It depends on your time frame. Many stocks have lost 50% of their face value and we don't know when the stock market will turn around. It could easily be five years. Dividends have been cut at many companies and more will be cut as these firms face refinancing of their debt in a restricted debt market. The simple answer to your question/comment is how much risk do you wish to have? Preservation of capital is more important in a deflationary environment. Regarding overall reurns going forward, corporate debt has a greater chance of delivering greater returns than stocks and has a higher spot in the pecking order on the balance sheet than stock. Credit spreads will tighten and bond prices will increase.TIPs are but one part of the overall debt structure and are now priced attractively as Richard Shaw clearly notes. TIP's, not Treasuries, make sense in an overall tax deferred portfolio. I am also short the 30 year Treasury.


On Dec 31 08:37 AM dividendmachine wrote:

> Maybe someone can explain this to me? How can a "TIP " at a lw interest
> rate OUTPERFORM the biggest American tobacco company which pays 8.5%
> dividend and controls 50% of a market where the government is 10
> trillion in debt ,states are bankrupt and no one can advertise?

2008 Dec 31 10:37 AM

[notsosmart:]

fabian hug makes the best point.you cant believe our govt. figures for anything.worse-yuo cant believe anybody about anything. happy liars new year.

2008 Dec 31 10:49 AM

[puttster:]

Advisors recommending TIPs always talk about the inflation protection but leave a hole where their discussion about interest rates should be.

Statements like "TIPS are anticipating no inflation for at least 7 years" is plain misleading. TIPS might be anticipating 10% inflation - and 10% interest rates, too. In which case they could easily be overpriced.

Jan 02 11:33 AM