TIPS: Cheap Inflation Insurance

According to Bloomberg, as of July 5, 2009, the real, inflation-adjusted yield on Treasury Inflation Protected Securities (TIPS) is as follows:

Bloomberg Treasury Yields:

Break-Even Rate

Because TIPS have inflation expectations baked in, they pay a higher coupon than Treasuries.

The difference between the yield on TIPS and the yield on 10 year Treasuries is called the “break-even inflation rate.” To some extent, the break-even rate is an an imperfect measure of the market's inflation expectations for the next 10 years.

The current break-even rate is 1.66%

Inflation Expectations Rising

Two months ago (as of 4/27/09) the yield on 10-Year Treasuries was 2.98% and 1.50% on 10-Year TIPS and a break-even inflation rate of 1.48%. Therefore, inflation expectations have risen slightly

Buy TIPs or Treasuries?

30 year Treasuries are at 4.32%. The historical inflation-adjusted yield over the the past 100 years on Treasuries has been 3.00%. A purchaser of 30 year Treasuries today would have to have an average of 1.32% annual inflation over the next 30 years in order to obtain the average real return of 3% {source: Siegel}.

The chances of average annual inflation of 1.32% over the next 30 years is near zero, because the long term inflation rate in the US has run at 3.5% and the US is facing significant inflationary headwinds due to the rapidly expanding deficit and monetary base. Treasuries are priced dearly.

TIPS as well, are no bargain in and of themselves. When they were first introduced in 1997, they offered real yields near 4%. The current real yield on 10 year TIPs is 1.84%, below the historical 3% inflation-adjusted return of government bonds.

US CPI

There is controversy over the accuracy of the official CPI. The official CPI determines the inflation adjustment that increases the value of the TIPS bond and interest payments. Many skeptics, myself included, feel that the US Government is under-reporting inflation. Some feel that the underreporting is 3%/year. Others (myself included) feel that the underreporting is 1%/year. If the latter is true, this gives 10 year TIPS a real return of 0.84%.

Inflation Insurance on the Cheap

With a break-even rate of 1.66%, if the investor feels that over the next decade, average annual inflation will be less than 1.66%, then, in theory, Treasuries will be the best bet. If an investor feels that inflation will be higher than 1.66%, then TIPS will be the best bet. TIPS are a bargain compared to nominal Treasuries, in that they currently provide inflation insurance at a very low cost.

My feeling is that inflation will be higher than 1.66% over the next decade and investors can buy inflation insurance cheaply with TIPS.

Summary

I am a huge fan of equities and minimize the use of bonds in my portfolio. Both TIPS and Treasuries offer below average forward returns. Avoid nominal Treasuries. TIPS are no bargain in of themselves, but, are a bargain when compared to Treasuries. While not to be bought for their yields, TIPS offer cheap inflation insurance for the investor worried about inflation. For some reason, if you absolutely, positively have to buy dollar denominated bonds, then buy TIPs. They can be purchased as individual bonds, or in ETF form, symbols IPE and TIP.

Full Disclosure: Author is long U.S. TIPS and WIP. You should always consult with a professional before investing.

Comments

[American in...:]

Ah, yes, and you pay taxes on the iinflation adjustment to the principal ...

I would definitely keep them in a tax protected account.

Jul 06 10:15 AM

[Marli:]

Glad to see you've addressed the issue of underreported CPI figures, but you've only scratched the surface here. The biggest component of inflation for the next decade or so is likely to be related to food prices, fresh water and energy, which as a % of overall CPI tend to be relatively low compared to the real world cost of living as the Fed tries to smoothen out 'volatility' in the time series.

As a result, they aren't as dynamic as they should be in updating the weightings for CPI components- especially when doing so would point to a higher rate of inflation.

In the interim, I intend to compare TIP index time series data against two sets of CPI statistics- those officially reported by the fed, as well as those published by shadowstats. I'm curious as to whjat I will find, and will try to be as objective as possible.

Jul 06 10:32 AM

[whidbey:]

Love your ideas, but TIPS are not my idea for live investors.

I think your dividend play ideas are the center post of a sound plan that will manage both deflation and inflation (which is dimming as a prospect). Dividend paying firms with strong franchises will reward the wait for a return of growth, and they will out run inflation if that is in the cards later.

Jul 06 10:34 AM

[Living4Divi...:]

Absolutely, AIP - TIPS only in a tax-sheltered account. Thanks for pointing that out.


On Jul 06 10:15 AM American in Paris wrote:

> Ah, yes, and you pay taxes on the iinflation adjustment to the principal
> ...
>
> I would definitely keep them in a tax protected account.

Jul 06 12:03 PM

[Living4Divi...:]

Thanks Marli, for you compliment on the article.

As for Shadowstats: other "economists" have differing ideas. It isn't wise to trust one sole source for your information. Consider many differing opinions and then form your own opinion

On Jul 06 10:32 AM Marli wrote:

> Glad to see you've addressed the issue of underreported CPI figures,
> but you've only scratched the surface here. The biggest component
> of inflation for the next decade or so is likely to be related to
> food prices, fresh water and energy, which as a % of overall CPI
> tend to be relatively low compared to the real world cost of living
> as the Fed tries to smoothen out 'volatility' in the time series.
>
>
> As a result, they aren't as dynamic as they should be in updating
> the weightings for CPI components- especially when doing so would
> point to a higher rate of inflation.
>
> In the interim, I intend to compare TIP index time series data against
> two sets of CPI statistics- those officially reported by the fed,
> as well as those published by shadowstats. I'm curious as to whjat
> I will find, and will try to be as objective as possible.

Jul 06 12:07 PM

[Living4Divi...:]

Yes, Whidbey,. I agree that equities should dominate, that's why I wrote "if you absolutely, positively have to buy dollar denominated bonds, then buy TIPs. "

thank you for your compliments on my article

On Jul 06 10:34 AM whidbey wrote:

> Love your ideas, but TIPS are not my idea for live investors. <br/>
>
> I think your dividend play ideas are the center post of a sound plan
> that will manage both deflation and inflation (which is dimming as
> a prospect). Dividend paying firms with strong franchises will reward
> the wait for a return of growth, and they will out run inflation
> if that is in the cards later.

Jul 06 12:10 PM

[Samsung:]

You are telling us something we already know - that treasury bonds are in a bubble. but I like the way you explain it. good article.

Jul 06 02:24 PM

[prairiedog555:]

Considering the under reporting of CPI figures, and the potential fall of USD, do you not consider WIP's a better investment?

Jul 07 07:45 AM

[oldman:]

I have some TIP's as insurance but since I am retired and 75, I need some cash flow. Bonds and/or bond funds provide that, Tips do not.
If I had to depend on too much stocks and dividends, it increases my risk too much.

Jul 07 10:31 AM

[Living4Divi...:]

You are correct - If the USD falls, WIP will be the better investment. However it would be foolish fora US based investor with expenses in dollars to invest all of his money in foreign bonds. However, the dollar will never fall in a straight line - see my earlier article seekingalpha.com/artic...

If you look at my other articles - I feel it is preferable for a US investor to hold some mix of US TIPS and foreign TIPS - diversification is best. Read through my articles on WIP and TIP and decide the appropriate mix for yourself.

On Jul 07 07:45 AM prairiedog555 wrote:

> Considering the under reporting of CPI figures, and the potential
> fall of USD, do you not consider WIP's a better investment?

Jul 07 01:55 PM

[Aldebert:]

When discussing TIPs and comparing them to fixed rate Treasuries, why doesn't anyone focus on the duration (and I am refering to real duration, i.e., interest rate sensitivity, as opposed to the term-to-maturity which is mislabled "duration" on the chart above)? For example, take a 10 year TIP vs. a 10-year Treasury. My thinking is that it doesn't make sense to compare the yields on the two because every six months, effectively interest rate on the TIP adjusts. That is the fixed coupon is applied to an adjusted principal amount. Thus the market value of the TIP is much less sensitive to changes in market rates and therefore less risky compared to the fixed rate Treasury. Now there is a question of the basis risk in that the changes in inflation that will be applied to the principal amount are not the same as the changes in the yield curve, but I am will to bet that in a rising inflation environment they will be correlated enough to protect me. I look forward to anyone else's thoughts on this.

Jul 07 02:03 PM

[Living4Divi...:]

Aldebert - you are 100% correct. IMHO - there is very little term risk on a TIP. With normal bonds, you get higher interest the further out you go on the yield curve. So with normal bonds - you want to stay short. With TIPS, the longer you have protection, the better.

While the interest rate adjusts on a TIP - it is minimal due to inflation/deflation. The major adjustment on a TIP is the par value adjustment for inflation. You don't get the cash until the bond matures. It is not technically interest, but effectively works like interest when considering the resulting nominal yield of the TIP

As for comparing 10 year TIPs with 10 year nominals - when comparing bonds, the only fair thing to do is to compare equal durations. It is done out of the interest of comparing apples with apples.


On Jul 07 02:03 PM Aldebert wrote:

> When discussing TIPs and comparing them to fixed rate Treasuries,
> why doesn't anyone focus on the duration (and I am refering to real
> duration, i.e., interest rate sensitivity, as opposed to the term-to-maturity
> which is mislabled "duration" on the chart above)? For example,
> take a 10 year TIP vs. a 10-year Treasury. My thinking is that it
> doesn't make sense to compare the yields on the two because every
> six months, effectively interest rate on the TIP adjusts. That is
> the fixed coupon is applied to an adjusted principal amount. Thus
> the market value of the TIP is much less sensitive to changes in
> market rates and therefore less risky compared to the fixed rate
> Treasury. Now there is a question of the basis risk in that the
> changes in inflation that will be applied to the principal amount
> are not the same as the changes in the yield curve, but I am will
> to bet that in a rising inflation environment they will be correlated
> enough to protect me. I look forward to anyone else's thoughts
> on this.

Jul 07 02:21 PM