Treasury TIPS: Back in Style

Alexander Wissel

Note: From Bloomberg, TIPS are starting to look good again. For years their yield wasn’t high enough to justify the speculation, but that’s starting to change. There’s a brief excerpt from Daniel Kruger’s article below. In addition, we’ve included a brief overview on TIPS and where you can find more about them.

“At a time when central banks are attempting to prevent deflation, the hottest investments in the government bond market are securities that protect debt holders against rising consumer prices.

Inflation-linked debt from the U.S. to Japan returned 5.77 percent since November, including price gains and reinvested interest, compared with 1.55 percent for the government-bond market, according to indexes compiled by New York-based Merrill Lynch & Co.

Pacific Investment Management Co., Vanguard Group and Fifth Third Asset Management, which oversee a combined $1.8 trillion, are scooping up so-called linkers on speculation efforts by policy makers to reignite the global economy will lead to faster inflation than is currently priced into the securities. Yields on U.S. Treasury Inflation-Protected Securities, or TIPS, indicate almost no rise in consumer prices for the next decade.

“They’re breathtakingly cheap,” said Mitchell Stapley, who oversees $22 billion as chief fixed-income officer for Grand Rapids, Michigan-based Fifth Third. “This one’s going to take a while to come to fruition but I’m buying them so dirt cheap I’m willing to have a little patience.”

Last year, inflation-linked securities lagged behind the rest of the government bond market through November, losing 5 percent, as the U.S., Europe and Japan entered simultaneous recessions for the first time since World War II and commodities prices as measured by the Standard & Poor’s/Goldman Sachs Commodities Index tumbled 60 percent from their peak July 11. Treasuries returned 14 percent in 2008, the most since 1995, according to Merrill indexes.”

To read the original article, go here.

Treasury Inflation Protected Securities (TIPS):

There are two types of inflation protected securities out there issued by the government - Treasury bonds (known to bond guys as “TIPS,” an acronym for “Treasury Inflation Protected Securities”) and U.S. Government Savings Bonds (I-series). They both basically work the same. You get paid by the government in two ways.

You receive:

• A guaranteed interest rate, PLUS
• You get paid back whatever the inflation rate is each year.

With these investments, the guaranteed interest rate portion of your income is fixed. The inflation rate portion of your income changes, so the total amount of interest you’ll get paid each year will vary. If inflation is 10% in one year, you’ll get a total of 12.25% that year. However, if inflation is -5% (negative), you WON’T be penalized - you just simply won’t be compensated for any inflation, as there was none. You’ll just get your 2.25% interest, and that’s it.

Last year, Alex Green recommended readers stay away from TIPS, and for good reason. But that isn’t the case now. To find more about TIPS, the Investment U archive contains a brief overview of what they are and how they work.

Comments

[bigmoney:]

my 401k was loaded up with TIPS, and I actually took about a 10% haircut in these over the past six months. I didn't think that was possible.

Jan 14 10:53 AM

[Rob Viglione:]

A major inflection point for TIPS, and hence for inflation expectations, occurred in late November. Since then TIP is up about 10%. Not too shabby for a low yield bond fund. The TIPS market will be the forerunner of a rush to inflation protection. The Fed academics keep telling us to expect deflation, but the average person is increasingly questioning the rampant printing press actions. Let's remember that inflation is, after all, predicated on expectations more than anything else.

The irony is that when markets return to nominal price normalcy we suddenly become at severe inflation risk. So to keep inflation at bay we hope for declining asset prices. But to keep our savings at bay we hope for increasing asset prices. In either case, the average American is screwed.

Jan 14 11:45 AM

[Chris B:]

I agree with everything said here. With massive upside potential and guaranteed return of capital (even if the govt. has to borrow at 20% interest to get that capital), what's not to like about TIPS?

Bigmoney, you (and I) have not lost anything in TIPS unless we sell cheap. Current market prices are just cheaper than the prices we bought at because deflationary expectations have increased. It's not like buying a company that may go out of business - the people who owe you own the printing press.

We are about to see a massive realization by market participants that the US government will not be allowing Japan-style deflation to endure for a decade - as current TIPS prices predict. This realization is less than 6 months away and will be a bigger disruption than the summer '08 change in inflationary/dollar sentiment. That's why I'm shorting treasuries via TBT and PST and going long TIP. Treasuries can't get much more expensive and TIPS can't get much cheaper.

0% treasury yields tell me that foreign money is looking for a liquid place to hide (after all, US citizens could just get a government insured bank CD yielding 3%). When that money flees, treasuries prices and the dollar will drop as the cash flows out of dollars and into foreign currencies. For investors who must hold ultra-safe dollar bonds, TIPS will seem like the best place to be in a stagflation environment.

Jan 14 12:18 PM

[Teutonic Kn...:]

To Investment U:

In a related article published in SA by Tradesense titled: "What do TIP and Treasury Yield Spreads Indicate?", the author listed two tables that show for the next 5 years inflation would likely be projected as negative, as the yield of TIP is predicted as higher than Treasuries. Their yields would then "break even" in about 7 years time.

View at seekingalpha.com/artic...

Question for you and ChrisB: ChrisB quoted "...0% treasury yields..." above. Am I missing something? Would the yields quoted by Tradesense be based on a longer period of maturity? If so, do we have to "compare apples to apples and oranges to oranges" in order to draw any meaningful conclusion?

One final thought, say, the economy tanked but interest rates stayed artificially low as "dictated" by the Fed (an 800-lb Gorilla!), but inflation flares. What would happen to TIP? (This is my humble believe and outcome).

Jan 14 02:17 PM

[Chris B:]

Teutonic Knight,

Yields for short-term treasuries are close enough to zero that it is accurate to say they are zero, much like my checking account can be said to have a zero interest rate despite paying 0.01% (the same yield as 3 month treasuries were going for last month). The interest can be said to be immaterial at those levels.

Longer term bonds such as the 10 year note offer higher rates as usual, 2.18% as of today: finance.yahoo.com/bond... . Could 10-year rates go lower? Technically yes, by 2.18%. In reality, anyone buying a 10-year bond at these expensive levels risks losing value if yields rise, if inflation returns, if the currency devalues, and from opportunity cost. Could 10-year rates go higher? Yes. To double-digits.

On your 2nd question, if the economy tanked and inflation increased (a stagflation scenario), the principal would increase by the official rate of inflation - the CPI - and the biannual interest payments, made at a fixed rate, would be based on your rising principal, resulting in those interest payments increasing. www.treasurydirect.gov...

Jan 15 11:00 AM

[Teutonic Kn...:]

Chris B,

Thanks for a thorough and comprehensive response. You answered well my questions. I also got myself educated from the two links you provided, and I even passed them onto other folks on the Yahoo blogs.

Teutonic


On Jan 15 11:00 AM Chris B wrote:

> Teutonic Knight,
>
> Yields for short-term treasuries are close enough to zero that it
> is accurate to say they are zero, much like my checking account can
> be said to have a zero interest rate despite paying 0.01% (the same
> yield as 3 month treasuries were going for last month). The interest
> can be said to be immaterial at those levels.
>
> Longer term bonds such as the 10 year note offer higher rates as
> usual, 2.18% as of today: finance.yahoo.com/bond... . Could
> 10-year rates go lower? Technically yes, by 2.18%. In reality,
> anyone buying a 10-year bond at these expensive levels risks losing
> value if yields rise, if inflation returns, if the currency devalues,
> and from opportunity cost. Could 10-year rates go higher? Yes.
> To double-digits.
>
> On your 2nd question, if the economy tanked and inflation increased
> (a stagflation scenario), the principal would increase by the official
> rate of inflation - the CPI - and the biannual interest payments,
> made at a fixed rate, would be based on your rising principal, resulting
> in those interest payments increasing. www.treasurydirect.gov...

>
>

Jan 15 06:58 PM