TIPS: Good in Deflationary and Inflationary Times 16 comments
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Prudent asset allocation tells us that some of our portfolio should be allocated to bonds. While there are some bargains currently in corporate bonds, to protect your principle, the safest bonds are US Treasury bonds.
There are two classes of US Treasury bonds: inflation-indexed and nominal. Nominal US Treasuries are extremely liquid, are denominated in the world’s leading reserve currency, the US dollar, and are backed by the Federal government.
Treasury Inflation Protected Securities (TIPS) are Treasury bonds that provide an inflation hedge. TIPS pay a fixed coupon plus an adjustment to the coupon that rises with inflation and falls during deflation. The principle of the bond is indexed to inflation using the Consumer Price Index (CPI).
TIPS have all of the safety features of nominal US Treasuries, and they add an additional measure of protection: inflation-protection. TIPS are slightly less liquid, due to the outstanding issue of $300 billion.
Because nominal bonds have inflation expectations baked in, they pay a higher coupon than TIPS.
The difference between the yield on TIPS and the yield on 10 year treasuries is called the “break-even inflation rate.” The current yield on 10-Year Treasuries is 2.98%. The current yield on 10-Year TIPS is 1.50%. This yields a current break-even inflation rate of 1.48%. (All data is from Bloomberg as of 4/27/09)
During the market rout late last year, the breakeven rate fell briefly below zero, reflecting fears of deflation. This is silly, because TIPS do not deflate below their par value.
For investments, it is the return AFTER inflation (or after deflation) that is the most important. Since no one really knows what the future rate of inflation or deflation will be, let’s consider three scenarios for two investors, Nominal-Guy and TIPS-Guy, who each buys 100,000 of US 10 year US government bonds and holds them to maturity.
REAL RETURNS AFTER 10 YEARS:
Scenario 1: 1.48% average inflation over 10 yrs:
- Nominal-Guy earns 1.5% per annum.
- TIPS-Guy earns 1.5% per annum.
RESULTS: They break even.
Scenario 2: -3.00% average inflation over 10 yrs (negative inflation = deflation)
(30% total deflation that occurred during the Great Depression, worst case)
- Nominal-Guy earns 2.98%+3% deflation = 5.98%
- TIPS-Guy earns 1.35%+3% deflation = 4.35%. (Only the interest is deflated)
RESULTS: Nominal-Guy wins by 1.63% per year.
Scenario 3: 5.00% average inflation over 10 yrs:
- Nominal-Guy earns 2.98%-5.00% = -2.02% (negative real yield) per annum.
- TIPS-Guy earns 1.5%+5.00%= 6.5% per annum.
RESULTS: TIPS-Guy wins by 8.52% per year at a minimum.
THE OTHER SHOE
The biggest risk to TIPS is that the creditor (the US government) also calculates the official CPI. This is a conflict of interest. Along with many others, I don't trust the official US government CPI figures. The CPI statistic has indeed been fudged to make inflation appear to be lower. This cheats Social Security recipients and TIPS bond holders. No one can agree on how much the US is fudging the CPI. One economist, John Williams, author of shadowstats.com believes that the US government is fudging the CPI by 3% per year.
Suppose the author of shadowstats.com was 100% accurate. Many respected economists would join the outcry against the government cheating and there would be tide swell of a moral outrage. I believe that cheats get away with cheating for a long time as long as they keep the amounts small.
I tend to side with Bill Gross of Pimco (the bond king) who feels that the US is underreporting inflation by 1% per year. With that headwind, 10 year TIPS are slated to provide a guaranteed 0.5% annual real return. To me TIPS are my “safe money” - the ace card in the hole.
Individual TIPS bonds can be purchased directly from the treasury, or on the aftermarket or in the form of an ETF, symbols TIP and IPE.
The TIP ETF has an ER of 0.2%. It provides a diversified portfolio of TIPS. I doubt the merit of spending 20 basis points for the diversification benefit. The bonds inside the ETF are from the same issuer, there is some diversified maturities and coupon rate. You could achieve an equivalent diversification with a handful of TIPS at different maturities and coupons.
Buying individual bonds is more complex than buying stocks. It requires a few hours of study to understand the concepts of par, discount, and yield to maturity and lot size. It is also more expensive: Vanguard, for example charges you $45 per bond trade.
TAXES
One drawback to TIPS and bonds in general is that you pay annual taxes on the interest and the inflation adjustment payments. Worse yet, you pay taxes at the normal (ordinary income rate). Say you are in the 33% income bracket and inflation is 6%. You get 1.5% interest plus 6% inflation = 7.5%. After you pay 33% (1/3) in taxes you keep 5%. You haven’t even kept up with inflation! (You lose 1% a year in real terms.)
The tax problem is just as bad for nominal bonds. The same investor with 3% 10 year Treasuries earns 2% after taxes. She loses 4% per year in real terms.
To solve this problem, hold TIPS and nominal bonds in a tax-sheltered account.
CONCLUSION
The upside on TIPS is unlimited (during inflation); the downside (during deflation) is minimal. The upside on Nominal Treasuries (experienced during deflation) is limited, but the downside (during inflation) is severe. TIPS are best held in a tax-sheltered vehicle such as an IRA, 401K or ROTH.
Disclosure: Author is long individual US TIPS. Author is not a registered investment advisor. You should consult with your investment advisor before investing.
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This article has 16 comments:
-AM
1. Interest rates could rise - making low yielding bonds drop in value.
2. The US Dollar falls in value.
3. Inflation rises far above expectations.
On Apr 29 09:36 AM oldman wrote:
> I do consider TIP's a great holding and I own the ETF and an individual
> bond matures 7/15/16. But these are not for cash flow, which I need
> at my age (75). where do you suggest for cash flow?
On Apr 29 09:36 AM oldman wrote:
> I do consider TIP's a great holding and I own the ETF and an individual
> bond matures 7/15/16. But these are not for cash flow, which I need
> at my age (75). where do you suggest for cash flow?
As for reliable, dependable dividend payers, frankly I don't know if there is any company you can trust. No one has a safe dividend. This is of very real concern to myself, personally. I am working on an upcoming article to address that topic.
On Apr 29 09:36 AM oldman wrote:
> I do consider TIP's a great holding and I own the ETF and an individual
> bond matures 7/15/16. But these are not for cash flow, which I need
> at my age (75). where do you suggest for cash flow?
On Apr 29 10:34 AM Emerald wrote:
> Try a Ginnie Mae bond fund where the underlying collateral is guaranteed
> by the government. Current yield around 4.6% and pays monthly. Some
> repayment risk but minimal today and some interest rate risk if rates
> skyrocket. Average duration is effectively around four years to minimize
> rate risk. Note: Long a Fidelity and Vanguard GNMA bond fund. Also
> the SHY (1-3 year Treasury ETF) that pays approximately 2% today.
>
- AM
On Apr 29 07:55 AM Living4Dividends wrote:
> Atlasman - While Treasuries are regarded as pretty safe, they are
> definitly NOT risk-free !
On Apr 29 12:27 PM Living4Dividends wrote:
> Oldman - As for Equity Income Stocks, that is "stable dividend payers."
> Those are a dying breed. It isn't just the Financials doing the cutting:
> Dividend stalwart GE (A quasi-financial) just broke it's decades
> long streak of increasing dividends. Pfizer, who has plenty of cash
> money, just cut their dividend to fund their empire-building acquisition
> of Wyeth.
>
> As for reliable, dependable dividend payers, frankly I don't know
> if there is any company you can trust. No one has a safe dividend.
> This is of very real concern to myself, personally. I am working
> on an upcoming article to address that topic.
>
> On Apr 29 09:36 AM oldman wrote:
I thought long and hard about buying GE for the very same reasons. My only holdback is that GE cut the dividend. A company cutting the dividend is like an employee stealing from you - if they did it once they will be sure to do it again. This employee need to be fired.
Furthermore - academic studies have shown that dividend cutters and eliminators historically have underperformed the market. Having said all of that if I were ever to make an exception to the rule of "never buying a dividend cutter" - it would be GE. These are exceptional times.
I can't put a link to it in the comments section, but the title is:
"WIP and TIP: Better than Gold" ( Apr 30, 2009 )
It is in my articles list