TIPS Can Help Improve the Fiscal Situation

Everyone asks for tips: Where can I put my money? Stocks or bonds have done very badly over the last year, needless to say, and one cannot be confident that they have hit bottom. Should one just leave everything in banks and money market funds? Surely there must be something else worth buying?

Inflation-indexed bonds (TIPS in particular, the acronym for Treasury Inflation-Protected securities) seem an undervalued asset. Using the conventional break-even approach, TIPS have lately implied an implausibly low long-term US inflation rate: 1% at the 10-year horizon and less than zero at the 5-year horizon. Is the explanation that people fear deflation? It is hard to see that we could have negative inflation for many years. I suspect the standard calculation of the implicit TIPS premium for expected inflation doesn’t even take into account the asymmetric form of their indexation, which makes them something of a one-way bet: When the security matures, the U.S. Treasury pays the original or adjusted principal, whichever is greater. Surely the market is not correctly pricing TIPS. One implication is that they cannot be relied upon as an indicator of expected inflation. Another is that we should all buy them.

Of course I am not the first one to have noticed this: quite a few others have pointed it out in recent weeks and months. Indeed the prices of TIPs have begun to recover a bit since the beginning of the year. But I think they have further to go.

Perhaps the Fed should buy TIPS, alongside all the other assets it is buying. Or the Treasury should swap them for conventional long-term Treasury bonds, now that investors are pushing the price of the latter down in response to huge increases in supply (i.e., are finally demanding higher returns on long-term Treasuries). Either strategy should help a bit to improve the country’s endangered long-term fiscal situation.

Comments

[Rob Viglione:]

It is almost guaranteed that 10-year inflation will exceed the 1% per annum rate, particularly with the insane pace of money creation these days. Fiat currencies are strained, so hedging inflation at this point would not be a bad idea. If TIPS are implying 1% inflation for that period I'd say this is more arbitrage than anything else.

Feb 22 05:59 AM

[sligoo:]

I bought TIPs. How do I figure the yield....no dividends since October!?

Feb 22 07:31 AM

[John Lounsbury:]

sligoo - - -

TIPS pay interest twice a year. If you bought TIPS from Treasury Direct in October, your first interest payment will be received in April. If you bought TIPS on the secondary market, the interest payment will be at six month intervals based on the original issue date.

Feb 22 11:23 AM

[John Lounsbury:]

A general comment about TIPS: These are the only intermediate and long-term bonds I have in accounts at present. I have no other bond holdings with maturities longer than one year.

Feb 22 11:26 AM

[Mad Hedge F...:]

If you believe that imminent and massive Treasury issuance is going to pop the Treasury bond bubble, and that Obama’s reflationary policies are long term inflationary, you have to be looking at Treasury Inflation Protected Securities. TIPS offer investors a US government guaranteed protection against future price hikes by raising the principal in line with the inflation rate. A 3% coupon TIPS facing a 10% inflation rate automatically boosts the face value of your bond from an issue price of 100 to 110, giving you a total return of 13%. You can buy these directly from the US Treasury, or buy the iShares Lehman TIPS Bond Fund (TIP). The best time to buy flood insurance is at the end of a long drought.

Feb 22 01:08 PM

[_richard_:]

Actually, TIPS in an ETF or mutual fund did not pay interest in October.

TIPS adjust for inflation, and for the last half year there's been mostly deflation. The ETFs and mutual funds of the world pay out the dividend as interest plus inflation adjustment, so when there is positive inflation the principal adjustment is paid out as well as the interest. During deflationary times, of course, the interest is overwhelmed by the deflation--so no payout.

For holders of the actual bonds, of course, this isn't the case--the payout of 2% or so comes out like clockwork.

Feb 23 07:03 PM

[Jeff Frankel:]

I am glad to see that I am in good company.
JF


On Feb 22 11:26 AM John Lounsbury wrote:

> A general comment about TIPS: These are the only intermediate and
> long-term bonds I have in accounts at present. I have no other bond
> holdings with maturities longer than one year.

Feb 24 01:51 PM

[R.S.:]

Dr. Frankel, thank you for your comments on TIPS. Last March, you posted an article recommending munis. Would you please revisit that issue? For individuals holding a ladder of munis, the current economic situation raises anxieties.
Thanks.

Feb 24 04:39 PM

[Georgey:]

what are the pros and cons for purchasing thru etf or trasurydirect ?

Mar 08 12:30 PM