Holding Cash? Might as Well Hold TIPS Instead

This comes in response to a reader's question. TIPS are a bit of a challenge to value, since they have several potentially valuable characteristics: 1) the real yield paid to the investor, 2) the future inflation adjustment paid to the investor, and 3) the change in the market price that may occur (which is determined by the change in the real yield). This chart focuses on the first characteristic, the real yield to maturity of 10-year TIPS, which is a decent proxy for where the TIPS market happens to be. (Right now, short-maturity real yields are about 1%, while long-maturity yields are 2.4%.)

The colored valuation bands on this chart are my creation. I think that on the basis of their current real yield, TIPS are not undervalued, and are actually a bit overvalued.

To step back for a minute, it is important to note that TIPS offer the only real yield that is guaranteed by the U.S. government; it is the coupon paid on TIPS whose face value is adjusted daily (prorata) for changes in the CPI two months earlier. No other security promises a guaranteed return above the rate of inflation. As such, the real yield on TIPS is extremely unlikely to rise beyond the 4-5% level, whereas the nominal yield on Treasuries can theoretically rise without limit. Why? Because the world's investors could not possibly turn down the opportunity to make a 5% guaranteed real yield for 10 years—no asset class could compete with that. Real yields could conceivably fall below zero, however, but I think that would only happen in a scenario in which inflation rose dramatically (into double digit levels) and demand for TIPS proved to be extremely strong. At that point an investor would effectively be giving up some of his inflation adjustment for the privilege of being protected against raging inflation.

As for the second characteristic, TIPS look to me to be cheap relative to Treasuries. That's because the difference between the yield on TIPS and Treasuries of similar maturity (which equates to the market's expectation of future inflation) is only a bit over 2%. The market expects the CPI to average about 2.1% over the next 10 years, whereas it averaged about 2.5% over the past 10 years. I think there's a good chance that inflation will be more than 2.5% on average going forward, so that means that the Treasury market, internally, is undervaluing TIPS. This in turn means that you should prefer TIPS to Treasuries.

As for the third characteristic, I think the likelihood of price gains relative to current prices is low. The one significant risk faced by TIPS investors today, in fact, is that their market price is likely to fall when the Fed starts tightening policy, and especially if they tighten policy sooner than expected.

To sum up, I don't think you are going to make a killing by buying TIPS today, unless inflation truly skyrockets. TIPS are best thought of as a guaranteed way to keep money safe from inflation while also earning a modest real yield. If you currently own Treasuries, you might be wise to trade them in for TIPS. If you currently hold cash as a hedge against risk in general, you might be wise to hold TIPS instead.

Comments

[woollyB:]

Let's not forget that we haven't really experienced any severe inflation since TIPS were created, so buying TIPS to protect against hyperinflation might be about as useful as buying portfolio insurance to protect against the 1987 crash.

Nov 05 04:07 PM

[_richard_:]

There's one other protection TIPS provides: for recently purchased TIPS, there is protection against deflation as well. TIPS cannot fall below their par value, although the adjustment to older TIPS can be adjusted downward. In an environment that today (not five years from now, but today) might turn out to be deflationary, getting 2% return and no deflationary adjustment might turn out to be better than Treasuries, with all the same protections that TIPS offer if the world turns out to be inflationary five years from now.

Nov 05 05:13 PM

[JeffDB:]

TIPS probably are a better/safer investment than regular old Treasuries of similar maturities but I think there might be a couple of other factors that might be taken into account.

I realize they may be considered non-factors by some/many people, but it seems to me they should at least be brought up in the discussion, even if only to be addressed and dismissed.

1. Many economists and even more consumers think the CPI numbers understate the actual inflation in the economy. www.shadowstats.com/ar... Social Security recipients have often complained that their COLA increases don't keep up with the rise in prices they experience in their everyday lives. The "real" yields listed above assume that the TIPS interest is 100% over and above the actual inflation rate, but I don't think that is an assumption people can necessarily take for granted at face value. There is after all a bit of a conflict of interest in that the issuer of the bonds is also the one who calculates what the inflation rate & hence the payout of the bonds will be in the future. If the government ever gets in a serious bind there could be some significant pressure to have those CPI numbers come out as low as possible.

2. In comparing cash vs TIPS I think liquidity could potentially enter into the equation. I remember reading some years back an economist warn against the possibility that if the government ever got into a serious crisis they could mandate that Treasuries that were expiring had to be rolled over or put other restrictions on taking money back out. I hope that's an extremely low probability but I personally think something like that could be an outside possibility at some point.

We are after all up to our eyeballs in debt, not even counting all the off-book unfunded liabilities like Social Security & Medicare nor all of the MBS and Agency debts and government guarantees for the FDIC etc. and have $1 trillion + deficits projected out as far as the eye can see. We're also seeing multiple other countries publicly complaining and warning about the monetarisation of our debt, converting dollar reserves into gold and other commodities and even the IMF has called for taking away the reserve currency status of the US $. Folks working at rating agencies have even spoken of the likelihood of a downgrade in the ratings of the US dollar.

Nov 05 10:26 PM

[ebworthen:]

Real yield - yes, I own TIPS, it's the only way to have the government compensate me for giving trillions of mine and others future taxed earnings to "banks" for 0% interest to lend out at 5-29% to reflate the bubble.

Oh yeah, I like physical Gold and stocks too.

The social and political situation is close to Jimmy Carter and the 70's, so stagflation and high interest rates are possible as the whiplash of the liquidity measures and money printing work through the economy and rear their ugly head.

Nov 05 11:51 PM

[The Simple ...:]

The Fed has consistently signaled that deflation will not be allowed, come what may, so the inflation trade is the order of the day. Few things have ever been more obvious for the portfolio manager

An easy, and relatively lower risk, inflation trade for those uncomfortable with the volatility of the commodity markets: TIP + TBT

Nov 06 07:50 AM

[geohjr:]

This approach, keeping cash in ETF bond funds like TIP TLT, is working well for me. For a number of reasons;

It forced me to learn about bonds which I originally had little interest in. Learn what duration is,

I hated having cash not earning anything even though I needed it for reserves and buying corrections,

Forgive me here; you can trade your cash with little beta, small commissions and low etf mgt fees and add some return, making your cash portion much more interesting,

last but not least, it introduced me to TBT , 2x treasury short, which is now part of my trading funds and which I believe will have an upward bias for some extended time.

Anyways, great concept. Thanks for the encouragement.

Nov 06 08:42 AM

[djj420:]

TIPS would be great if there was an independent audit to set them at an actual inflation rate instead of the bogus rate the government announces. If you buy a vehicle to capture inflation, don't buy it from a party with a vested interest in ignoring real inflation by juicing the numbers.

Nov 06 08:55 AM

[Thomas Smic...:]

Good article and good individual commentary.

A case can be made for deflation and inflation. I fall into the inflation camp but have not placed too strong a bet on this occuring - yet.

I prefer to own TIPS purchased online through the US Treasury Direct site. Another technique I have included in my scheme is to purchase 6 month T-bills through Treasury Direct and rolling them over upon maturity. True, the current interest is poor, but T-bills are secure and will capture the bump in inflation. I temper these low interest holdings with other securities that provide me with a dividend/interest spike, but that is not relative to this discussion.

I Bonds and E Bonds could also be a part of today's post.

Nov 06 09:08 AM

[Index Guy:]

You get very few of these protections unless you buy a TIP Bond on the offer and hold to maturity. Otherwise you're in the pool and subject to duration risk as the chart so deftly points out. Where does the line go from here? My guess is up - which means your value when you sell the bonds goes down (bond investing 101). The correlation with TIPs to inflation is less than .3 over the last 5 plus years....not a great proxy. As soon as the Fed starts raising rates, TIP investors should hold on because if they aren't holding the TIPs bond to maturity (the only way to get the inflation protected real return) and want to sell they'll get a real return that IS negative. CPI ETF is a better solution than TIP.

Nov 06 10:26 AM

[notsosmart:]

only valuable if you trust gov. figures. i never have-never will.

Nov 06 11:38 AM