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"By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens." - John Maynard Keynes

With all the easing the Federal Reserve has done since the start of the financial crisis back in 2008, a common concern among investors has been the prospect of runaway inflation. These inflationary forces have yet to materialize due primarily to the excess slack (read high unemployment, housing supply and consumer deleveraging) in the economy. That being said, prudent investors are still looking for ways to position their portfolio against hyper-inflation if or when it finally materializes. The knee jerk asset that many flock to for this purpose is the Treasury Inflation Protected Security (OTC:TIPS). It's a common misconception that the primary role of TIPS is as an inflation hedge, which reflects a lack of understanding of the intricacies of how TIPS actually work.

TIPS are in essence just another flavor of Treasury bond. There is a par value, a coupon and a maturity date just like a regular bond. The only difference is that coupon payments are adjusted for inflation, as measured by the Consumer Price Index ((NYSEARCA:CPI)), over time. A TIPS coupon payment is made up of two parts, the "real yield" plus realized CPI inflation. The real yield is known at the time of purchase, but future inflation is unknown and has to be estimated by the investor. It is possible to back into the market's expectation of the inflation component over the life of the bond by comparing the spread between the real yield on a TIPS to that of a normal Treasury bond of the same maturity. In equation format it looks like this:

Implied Future Inflation = Treasury Bond Yield - TIPS Real Yield

As an example, the 10-year Treasury is yielding roughly 1.6% while the yield on the 10-year TIPS is negative at -0.5%. That would imply that the market is pricing in or anticipating an inflation rate of 2.1% (1.6% - -0.5%) over the next 10 years. This spread is referred to as the "breakeven rate" because it's the rate of inflation at which a TIPS investor and a Treasury investor will end up realizing the exact same return if both are held to maturity over the ten year investment horizon. If CPI ends up coming in higher than 2.1% an investor will end up being better off in TIPS than in the normal Treasury bond, and vice-versa if CPI ends up coming in below 2.1%.

Keep in mind that just because TIPS might be outperforming Treasury bonds, it does not mean that they are guaranteed to make money in an inflationary environment. TIPS are still Treasury bonds, and as such their price performance between the time of purchase and maturity is subject to changes in nominal interest rates. For investors that purchase TIPS and hold to maturity, fluctuations in price may not matter, but for other investors who get TIPS exposure through ETFs like TIP, WIP, IPE, SCHP, & LTPZ (among others) which target a constant duration and don't hold bonds to maturity, changes in price are a significant part of their total return.

As a theoretical example, let's say that inflation expectations increase to 4.0% over the next 10 years. Going back to our equation above, this means that either nominal yields on Treasury bonds have gone up or real yields have gone down (or a combination of the two) to increase the spread from the current level of 2.1% to 4.0%. If the change in the breakeven rate is entirely due to increasing Treasury bond yields then the TIPS investor will not experience any price appreciation in their holding since the tailwind of increased inflation expectations is being offset by the headwind of rising Treasury yields. On the other hand, if the increase in the spread is due to the TIPS real yield component falling, then the TIPS investor will be handsomely rewarded as the price of their bond increases (falling rates equate to rising bond prices). If we re-write the first equation in terms of the real yield it looks like this.

TIPS Real Yield = Treasury Bond Yield - Implied Future Inflation

The key driver for TIPS investors is the change in the real yield component. Since TIPS investors want real yields to decline, they are hoping for either falling nominal Treasury bond yields or an increase in the market's expectations for future inflation. Therefore, an investment in TIPS is not only making a call on the future of inflation but also on the future of interest rates in general. This means that even in a scenario in which inflation is moving higher, a TIPS investor can still lose money if nominal Treasury yields are rising faster than the implied future inflation rate which would cause the real yield to rise.

(click to enlarge)2012-06-25_-_TIPS_Chart.png

It is not common for the 10 year TIPS real yield to be negative as it is today, which is shown in the embedded chart. A negative real yield implies that Treasury investors will lose purchasing power since inflation is expected to outpace the yield they realize on their bond investment. Today's negative real rates are a product of the Fed's financially repressive policy to keep nominal interest rates artificially low in order to push investors into riskier assets and thereby reignite animal spirits (a lofty goal to say the least). As long as the Fed continues down the road of keeping nominal rates artificially low while potentially stoking inflation expectations by debasing the currency, real rates can continue to fall further into negative territory than they are today.

We always analyze TIPS relative to Treasuries - not as a standalone inflation hedge. When rates are especially low like they are today, we prefer TIPS over Treasuries since TIPS provide a pseudo-hedge against rising nominal interest rates as long as the rise in rates is primarily due to increased inflation expectations (e.g. the real rate component isn't changing). Given the current lackluster growth prospects for the economy, the most probable driver of a rise in nominal interest rates is increased inflation expectations from loose monetary policy out of the Fed. Therefore, we consider TIPS a compelling alternative to normal Treasuries within our Fixed Income asset class as part of our Diversification 2.0 portfolio construction. Given how low yields already are, we believe commodities and gold (which we view as a currency) are far superior hedges against inflation than TIPS for a USD-based investor over time.

Transparency is one of the defining characteristics of our firm. This information is not to be construed as an offer to sell or the solicitation of an offer to buy any securities. It represents only the opinions of Season Investments and its principals. Any views expressed are provided for informational purposes only and should not be construed as an offer, an endorsement, or inducement to invest.

Source: TIPS, Not The Inflation Hedge You Might Think