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With inflation worries starting to surface and the US Dollar resuming its fall, many investment advisors have advocated the iShares Barclays TIPS Bond Fund (TIP). This ETF invests in Treasury Inflation Protected Securities, treasury bonds which promise to completely protect against inflation by calculating the coupon payment on inflation-adjusted principal.
The TIP is a smartly designed fund with an attractive expense ratio and plenty of liquidity. But it has one fatal flaw: TIPs haven't been tested in truly inflationary times, and are thus a much riskier investment than most people think.
The protective value of TIPs rests on an accurate calculation of inflation. Critics have long accused the CPI of underestimating the true value of inflation. Much like the unemployment figures, the CPI numbers have been openly massaged over time to look more benign. They aren't falsified per se, the index's parameters are simply changed in a way that produces overly conservative figures.
TIPs were first issued in 1997, smack in the middle of the "great moderation". They weren't tested in the 1970's. We don't know if the US government will pay them back honestly and in full. It may simply be easier and cheaper to lower the CPI numbers, leaving TIPs holders exposed. This excellent Bloomberg story describes how poorly TIPs performed in early 2008, right when pre-crisis inflation hit its peak.
The pressure on the US government to fiddle the inflation numbers will be overwhelming the next time inflation rears its head. The Fed wants to keep rates low to support growth. The Treasury wants to keep rates low to avoid raising its borrowing costs, both through higher interest payments and higher TIPs payouts. Every government in the world fudges their inflation numbers, and history has shown that the worst fudging comes in times of the worst inflation. With the US fiscal situation looking more and more dire, investors cannot rely on the flawed CPI to protect them.
Better, safer alternatives exist. The SPDR DB International Government Inflation-Protected Bond Fund (WIP) invests in inflation protected securities from a variety of non-US issuers. WIPs holdings are better credit risks, and their geographic diversity minimizes the chance that any one particular government will hurt your returns.
The ProShares Ultra Short 20+ Year Treasury (TBT) shorts the long end of the US treasury curve . Unlike the CPI rate, long term treasury rates are set by the market. (Although the federal reserve has recently tried to artificially support prices with quantitative easing, its policy has clearly failed.) As inflationary expectations rise investors will demand more yield for long term treasuries, causing prices to fall and TBT to rise.
Investors with more risk tolerance may want to invest directly in commodities, which are usually big winners in inflationary environments. Top picks would include the SPDR Gold Shares Trust (GLD), the Powershares DB Commodity Index (DBC), and the Powershares DB Agriculture (DBA). If you absolutely must invest in TIP, make it a small part of an inflation proof portfolio that includes exposure to international government bonds and commodities.
Disclosure: Author owns TBT.
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This article has 38 comments:
International TIPS are no better than those in the US - they fall victim to the same flaws in CPI calculations and will ultimately understate inflation.
I also have concerns about shorting us treasuries with TBT. Although you are right that the fundamentals of treasuries are terrible, the federal reserve is openly attempting to manipulate high prices and low yields in all treasuries and I'm reluctant to fight the fed head-on.
So just stick to GLD or the higher returning GDX for gold exposure; stick to DBA or its leveraged cousing DAG for ag commodity exposure; stick to DXO or perhaps PBW for energy exposure.
As I've remarked elsewhere, TIPS are now the ultimate sucker's bet.
I really do not understand why all the experts recommend TIPs.
I plan to move this into funds that should do better this year.
I agree with the rest of your comment (and the author).
On May 25 11:33 AM D. McHattie wrote:
> International TIPS are no better than those in the US - they fall
> victim to the same flaws in CPI calculations and will ultimately
> understate inflation.
But the point of the WIP is to diversify across countries so one county manipulating its CPI wouldn't destroy your entire holdings.
On May 25 02:28 PM Alan Young wrote:
> D. McHattie: Do you have any evidence for your assertion that European
> governments are manipulating inflation data, or are you merely assuming
> that all governments are alike?
>
> I agree with the rest of your comment (and the author).
What is of even greater concern is the confiscatory nature of the BHO Administration and the non-term limited Congress. They already have bit off more than they can chew without even considering their lack of management skill, experience or temperament. No one is holding them accountable.
Having barely survived during the Carter years I see the worst is yet to come. I, a military war veteran, love this country and am shocked with the blatant Fascist-styled takeover of industry, destroying pensions and the law of contracts, and virtually Nationalizing industries. What's next: Airlines, railroads, health services, etc.? They have the power and like most egomaniacs think they can do anything they wish and they may be right.
If you can tell me how the government can pay all its bills, run industries with statists, make political payoffs to unions and other political supporters and not bring down the economy I want to hear or read it as I have not to date.
On May 25 02:28 PM Alan Young wrote:
> D. McHattie: Do you have any evidence for your assertion that European
> governments are manipulating inflation data, or are you merely assuming
> that all governments are alike?
>
> I agree with the rest of your comment (and the author).
TIP can used as a trade, inflation scares will drive up the price and deflation scares can present a buying opportunity. Watch for high and low trading channels. A lot of it (TIPS valuations) is based on perception regardless of inflation fundamentals.
(TBT: inception date 4/29/08.
WIP: inception date of 3/13/2008)
Britain has been issuing TIPs since the 1981.
Does the GLD being created recently make gold a bad investment?
On May 25 06:29 PM nisiprius wrote:
> It takes a lot of chutzpah to complain that TIPS, which have been
> around since 1997, "haven't been tested in truly inflationary times,"
> and then go ahead to suggest, as a good alternative, two ETFs created
> in 2008!
>
> (TBT: inception date 4/29/08.
> WIP: inception date of 3/13/2008)
TIPS: Good in Deflationary and Inflationary Times 16 comments
by: Living4Dividends April 29, 2009 | about stocks: IPE / TIP
Living4Dividends
<snip>
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.
.
WIP and TIP: Better than Gold
by: Living4Dividends April 30, 2009 | about stocks: TIP / WIP
Living4Dividends
<snip>
Investment Vehicle - WIP
Name: State Street Global Advisors has a relatively new product called “SPDR DB International Government Inflation-Protected Bond ETF”, symbol WIP.
Description: WIP is a diversified basket of inflation-linked non-US government bonds. It is the non-US equivalent of the ETF TIP. WIP is a convenient way to diversify away from the US Dollar.
Holdings: The largest holdings in WIP are in the developed markets and in Euros and Pounds Sterling. The fund holds a wide basket of currencies including 31% in emerging markets (Brazil, Poland, Mexico, Turkey, South Africa, Chile, Korea, and Israel).
Default Risk: Even though developed country sovereign treasuries are generally considered safe, the funds holdings are at greater risk for default than the US. The riskiest assets in the fund are in Greece (4.33% of total fund assets) and Italy (4.84%) both are currently considered to be the Euro-area’s “sovereign debtors most likely to default.”
Yield & Expenses: The average real yield in the portfolio is 3.01% - double that of US TIPS. The only downside is the pricey expense ratio of 0.5%.
Fudging Risk: In an earlier article I said that US government is fudging the CPI to make inflation seem lower. The general consensus seems to be that the other currencies of the world for the most part, are much more accurate in calculating their respective CPIs.
<snip>
4. The US Dollar could drop in value. You are protected two ways: 1) The WIP account would increase in terms of nominal dollars. 2) Since the US is highly dependent on imports, the decrease in the value of the dollar would cause the price of oil and other imports to rise. Inflation would pick up, and you would be protected by the inflation linked feature of TIP.
5. The US Dollar could rise in value. The value of your WIP account in dollars would decrease, however the value of your dollars would increase. Your money would go further with imports.
<snip>
With respect to this article, readers might note
1. Any grandma can buy TIPS directly, easily, from the U.S. Treasury, and NO grandma should be paying manager fees to BGI for something this simple. Any TIPS investor should be a very long term buy-and-holder, not a tactical investor who's doing a shorter term inflation dance. And in that scenario, even if it's only 20bps, ANY FEE IS A SIGNIFICANT DRAG ON *REAL YIELD*. If one wants TIPs, www.ustreasurydirect.gov will set you up cheaper than Schwabbie
2. Furthermore, these "real asset proxy" ETF's are not impressing the hell out of anyone with their tracking error. Yes, they can be very useful. Still, for fun, throw USO on a chart against WTI Crude and sing me the "it's a daily tracker" song again, please please. ETF's are generally great for tactical, but not for long term strategic - particularly when you CAN invest in the underlying cheaply and easily.
3. The big giggle idea above is that the government could ever be so well coordinated that they throttle the CPI data for the benefit of the U.S. Treasury's bond expense. Like "left hand number 1,765,234" knows what "right hand number 1,987,456" is doing. Mmm hmmm. With roughtly $5.8 Trillion par of UST's outstanding and like $480B of TIPs, what do ya get by nudging the par uplift a point or two on only 8% of the UST's outstanding par?
You equity guys are funny enough, but when you bring the conspiracy cats - then we really have a party going on,... tap that second keg, Jeeves!
--rq
There was a behavioural research project years ago, where people were asked to state what they "thought" inflation had been for the past year, they the researchers looked at their credit card bills and spending. Turns out that most people overstate personal perceived inflation by 2-4%.
And inflation is differential by income--high income holders have had, over the last few decades, higher levels of inflation than median income households.
The adjustments to CPI-U--chaining, substitution and the like--tend to make a difference of less than 0.5%, sometimes more, sometimes less. In fact, a decade ago, the charge was that CPI-U _overstated_ inflation.
One poster did mention that taxation on TIPs is sure to make them net losers. His point is well taken, though it applies to any other investment as well--most people look at nominal returns and not real returns. If you bought a house 10 years ago and it is not worth 40% more than you bought it for and inflation is 3.5%, then you lost money. Same is true for equities as well.
With a true return over measured inflation of 2% and very low volatility, it's hard to make a case against at least a substantial chuck of a portfolio _not_ being in TIPs--especially if they are in a tax-expempt or tax-deferred account.
Disclosure: Long WIA and TBT
"SPDR DB International Government Inflation-Protected Bond ETF ... seeks results that correspond to ... DB Global Government ex-US Inflation Linked Bond Capped Index."
Holdings indications from
https://spdrs.com/product/fund...
You can download the holdings in a .csv file.
In no particular order, you've got some Euro, Brit, Brazil and Aussie, some Canada, Japan and Mexico IL bonds, among others. Each bond type is driven off a domestic CPI index, usually a sub-index off the headline CPI. For example, France uses the French CPI ex-tobacco (hilarious).
The "exact inflation measure" used is most easily looked up on a Bloomberg using the ISIN numbers (in the download file). Alternately, you can go to each countries' government treasury investor information webpages (hmm. enjoy).
--rq
On May 26 02:23 PM Vindicator wrote:
> Does anyone have a resource to identify the exact inflation measure
> used by the more significant holdings in WIP? Do any of them use
> US Govt CPI? Their own government's measure of inflation in their
> own single country? Some kind of govt or private measure of regional
> (Eurozone, for example) or global inflation?
On May 26 11:02 AM reluctantQuant wrote:
> 3. The big giggle idea above is that the government could ever be
> so well coordinated that they throttle the CPI data for the benefit
> of the U.S. Treasury's bond expense. Like "left hand number 1,765,234"
> knows what "right hand number 1,987,456" is doing. Mmm hmmm. With
> roughtly $5.8 Trillion par of UST's outstanding and like $480B of
> TIPs, what do ya get by nudging the par uplift a point or two on
> only 8% of the UST's outstanding par?
> --rq
RQ - The CPI is not managed to make TIPS more attractive. I cannot prove wehter the CPI is "artificially low"or not. However, let's look at the benefits to the U.S.Govt of an artificially low CPI:
a) Social Security benefits, would not increase as much (BIG SAVINGS)
b) Yields on regular treasuries would be less, because the yield is always higher in higher inflation.
c) various labor costs are indexed to inflation.
There is a HUGE incentive to mismanage the CPI and underreport inflation. IT saves the Govt tons of money.
"The CPI is a government statistic, and since the government's expansionary monetary policy creates the inflation, officials have an incentive to underestimate these numbers. Underreporting inflation helps government officials in at least three ways.
First of all, it provides more favorable economic news. Elected officials want to report and take credit for any positive economic announcements.
Second, if the government reports a rate of inflation that is lower than the actual inflation rate, this will increases tax revenues through bracket creep. If the actual inflation rate is 10%, but the measured rate of inflation is 4%, some taxpayers will be pushed into higher tax brackets even though their real income has not increased.
And third, a lower reported inflation statistic reduces government spending by limiting the spending increases that are tied to inflation. The state can take credit for cost of living adjustments that are allegedly keeping up with inflation although in real terms the payments are falling.
My point is that given the incentives facing government officials, we should be reluctant to put any credence in government statistics."
I agree that probably the best inflation protection is going to be precious metals and commodities.
Time to buy more GLD, SLV, UNG, and USO! Whee! This investing stuff is easy!!
Please, compare WIP to TIP during the credit crisis of this last year and tell us its a safer alternative (WIP had over 3 times the downside). Please. Then tell us to look at a leveraged (always scary) inverse fund in TBT. Finally, then tell us to buy ETFs that hold speculative commodity futures instead of AAA U.S. Government bonds with a (nothing new) debatable inflation index. Glad you're not managing my retiree's money.
Another consideration I had not seen mentioned in buying TIP is that TIPS, like regular treasuries are trading at extremely low "Real Yields." Normal real yields have been in the 3-4 % range while 5YR TIPS are currently trading at 1% and longer dated TIPS barely 2%. When "Real Yields" normalize, the price of TIPS will drop as "Real Yields" rise. TIP will be a poor inflation hedge when inflation picks up b/c that is when the Fed should tighten and drive Real Yields higher. I would avoid TIPS going forward unless you can hedge out some of the risk of real yields rising by shorting regular Treasuries.
TIPS have Real Yields. If inflation goes up, the real yield stays the same, because the issuer of the bond kicks in extra money to make up for the inflation. If you have a 1.5% TIPS, and you hold it to maturity, then your Real Yield will always be 1.5%, no matter what happens to inflation or nominal interest rates.
If 10 year TIPS have a real yield of 1.7% and 10 year treasuries 3.7% then the market is assuming that inflation will be 2% over the next 10 years. If inflation is zero - then the real yield on the Treasuries will be 3.7%. If inflation is 4.7% then the real yield on Treasuries will be negative 1%.
Nominal yields vary considerably: range has been 3%-15%+ over the past few decades. Real yields vary alot less.
On May 27 03:47 PM BondSpud wrote:
> Good article.
>
> Another consideration I had not seen mentioned in buying TIP is that
> TIPS, like regular treasuries are trading at extremely low "Real
> Yields." Normal real yields have been in the 3-4 % range while 5YR
> TIPS are currently trading at 1% and longer dated TIPS barely 2%.
> When "Real Yields" normalize, the price of TIPS will drop as "Real
> Yields" rise. TIP will be a poor inflation hedge when inflation picks
> up b/c that is when the Fed should tighten and drive Real Yields
> higher. I would avoid TIPS going forward unless you can hedge out
> some of the risk of real yields rising by shorting regular Treasuries.
Inflation-Deflation debate is totally unsettled. So do not make one way bets on TIPS or even Gold.
This economic crisis, however, is not a normal circumstance.
As we've now learned, AAA rated means preciesly nothing. And sovrign debt ratings are only intended to gauge the risk of default in the first place, not the risk of inflation eating away your returns.
If the federal reserve expanding the money supply expontnially and US running an budget defict worth 13% of GDP won't challenge your view of US sovrign debt as a risk free investment - I don't know what will.
WIP "had" over three times the downside. Past performance is not a gaurentee of future performance. The dollar rally was essentially a giant global margin call, a one off event that will not be repeated. I would rather place my money in a diversified basket of currencies and government securities, rather than simply rely on the US dollar and Uncle Sam.
And commodities may be risky (which I stated in the article), but even at their worst they have certainly performed better than the "investment grade" government bonds of say.....Iceland.
Unusual times call for unusual investment strategies. Your conventional wisdom critique makes me think you might have worked for one America's many storied investment banks....Bear Sterns? Lehman? Merrill Lynch perhaps?
Oh wait. Those firms are all gone, and they took their conventional wisdom and thier AAA rated debt with them.
On May 27 03:22 PM Etsh wrote:
> "Better, safer, alternatives exist".
>
> Please, compare WIP to TIP during the credit crisis of this last
> year and tell us its a safer alternative (WIP had over 3 times the
> downside). Please. Then tell us to look at a leveraged (always scary)
> inverse fund in TBT. Finally, then tell us to buy ETFs that hold
> speculative commodity futures instead of AAA U.S. Government bonds
> with a (nothing new) debatable inflation index. Glad you're not managing
> my retiree's money.
On May 28 02:48 AM ETF Grind wrote:
> As we've now learned, AAA rated means preciesly nothing. And sovrign
> debt ratings are only intended to gauge the risk of default in the
> first place, not the risk of inflation eating away your returns.
>
this is very true
>
> If the federal reserve expanding the money supply expontnially and
> US running an budget defict worth 13% of GDP won't challenge your
> view of US sovrign debt as a risk free investment - I don't know
> what will.
>
Taking your first statement as true, and since US budget deficit at 13% is inflationary in nature (and has nothing to do with risk of default). Then your second statement is false.
About Debt Ratings:
1. Being rated AAA does not mean risk-free. (given past actions of ratings agencies this is an accurate statement) It just means it is Less Risky than AA or A.
2. Within the same country, Sovereign Debt is always LESS RISKY than corporate debt
3. Bonds have four risks: inflation, currency fluctuations, devaluation and default.
4. Inflation-protected bonds protect you against inflation, and to a lesser extent against devaluation (because devaluation stimulated inflation). Because of this, inflation-protected bonds are less risky than nominal bonds (same issuer)
5. Diversification lowers risk: A diversified portfolio of sovereign bonds is far less risky than holding the bonds of a single foreign country. (This point is tempered by the fact that you are exposed to currency risk)
6. Diversification only works if done properly: Holding multiple bonds from ONE issuer does only a little to reduce risk. If the issuer defaults on one, they default on all. (e.g. ETF fund TIP - which holds all US IP bonds). There is a slight risk reduction by holding different maturities.
CONCLUSION:
1. If you wanted to hold FOREIGN BONDS, then a diversified portfolio of Inflation-Protected Sovereign Foreign Bonds (like WIP) are the least risky investment. 2. These bonds, when added to a portfolio of your native currency, will add diversification and depending on the amount added, should, in theory, cause the portfolio to be less risky than a portfolio of 100% bonds in your native currency. The proper mix of foreign/local remains to be seen and depends on what your optimizer tells you.
On May 28 02:48 AM ETF Grind wrote:
> view of US sovrign debt as a risk free investment - I don't know
> what will.
>
the math almost assures that these things trend to zero.
just check the chart of fas and faz from jan 1, 2009 to today if you don't believe me. you could be triple long AND triple short the same index and lose 60% on EACH SIDE!
that's because quite simply put every time you lose 20% you need to gain 25% to make it up and these things are recalculated daily.
just a huge scam.
the math almost assures that these things trend to zero.
just check the chart of fas and faz from jan 1, 2009 to today if you don't believe me. you could be triple long AND triple short the same index and lose 60% on EACH SIDE!
that's because quite simply put every time you lose 20% you need to gain 25% to make it up and these things are recalculated daily.
just a huge scam.
As to WIP, the dividend yield is miniscule, and could easily be wiped out by a fall in the NAV caused by a modest rally in the dollar. One major risk of owning international bonds is the currency risk. If the dollar gains in value, the value of this ETF will most likely fall in value. The same is true for another international bond ETF that I own, BWX, where I make an effort to manage the currency risk by paring when the dollar falls in value, using the Dollar Index chart, and adding when the dollar is in a rally mode. So I was buying BWX last Fall, in the 47 area tennesseeindependent.b..., and then I just sold sold some at 54. tennesseeindependent.b.... Investors need to be mindful of the foreign currency risk when delving into this area. David Swenson recommends against individuals buying foreign bonds for that reason, and he makes good points on that issue. Since I am comfortable managing the currency risk, I will venture into buying some international bonds.
As to TIP, I recently published a post in my blog discussing its advantages and disadvantages. tennesseeindependent.b... One disadvantage not mentioned yet is the inherent problem of owning bonds via a mutual fund or an ETF. Remember, the fund does not have a maturity date. It does not promise to pay you back your original investment. If we enter a a long term secular bear market in bonds, it is conceivable that a buyer of bond mutual funds or ETFs will lose part of their principal and even an amount equal to or greater than the value of the reinvested dividends. I would not assume a continuation of a bull market in bonds. For those of you old enough to remember, there was a long term secular bear market in bonds starting around 1946 and ending in 1981: tennesseeindependent.b...
I intend to gradually transition to buying treasury inflation protected securities in my ROTH, directly from the Treasury at auction, which can be done via my broker at no charge, and then holding them to maturity. That way I am assured of receiving the greater of par value or the principal adjusted by the CPI accretions. tennesseeindependent.b... And I do expect that there will be accretions.
On May 27 06:59 PM Living4Dividends wrote:
> Treasuries do not have "Real Yields" Instead, they have nominal yields.
> The real yield of a treasury is the nominal yield minus inflation.
> When inflation goes up, investors demand higher nominal yields on
> BRAND NEW treasuries, so they can still get a positive real yield.
> If you happen to be holding a lower-yielding treasury, before inflation
> hits, it sucks to be you. Suppose you are holding a 3.5% treasury
> and inflation goes to 4.5%. Your real yield is now negative 1% -
> therefore - you are losing money.
>
> TIPS have Real Yields. If inflation goes up, the real yield stays
> the same, because the issuer of the bond kicks in extra money to
> make up for the inflation. If you have a 1.5% TIPS, and you hold
> it to maturity, then your Real Yield will always be 1.5%, no matter
> what happens to inflation or nominal interest rates.
>
> If 10 year TIPS have a real yield of 1.7% and 10 year treasuries
> 3.7% then the market is assuming that inflation will be 2% over the
> next 10 years. If inflation is zero - then the real yield on the
> Treasuries will be 3.7%. If inflation is 4.7% then the real yield
> on Treasuries will be negative 1%.
>
> Nominal yields vary considerably: range has been 3%-15%+ over the
> past few decades. Real yields vary alot less.
>
> On May 27 03:47 PM BondSpud wrote: