Every investor needs a benchmark. Picking a relevant one is a challenge, in part because the menu is crowded. The good news is that there's a great starting place for everyone: the yield on the 10-year inflation-indexed Treasury Note, a.k.a., the 10-year TIPS.
As guaranteed payouts on Mother Earth go, this one's about as solid as they come. Not only can you sleep easy knowing that your principal will be returned, the payout in the years ahead will be immune from inflation. Yes, one can argue that the underlying inflation yardstick--the consumer price index--is flawed, but we'll leave that glitch aside for the moment.
Accepting the 10-year TIPS at face value gives us a robust benchmark for comparing and contrasting our investment strategies. It is, in short, the true risk-free benchmark for investors considering the rainbow of risks in the world to embrace or avoid. Yes, we could quibble and cite the 5-year or 20-year TIPS. But we'll split the difference and use the 10-year span, in part because much of bond investing revolves around decade-long maturities as benchmarks.
As of last night, a 10-year TIPS yields 1.69%. The question before the house: can you beat it? That is, will your investment strategy generate more than a 1.69% return--after inflation--when you crunch the numbers on September 3, 2018?
No doubt some, and quite probably many investors will answer in the affirmative. But the task ahead is tougher than it appears. Why? Several reasons, starting with the fact that buying and holding a 10-year TIPS is a strategy with no moving parts. As such, there's no chance for error in executing the strategy and grabbing the yield as stated. But as history suggests, a fair share of investors who try to excel at the money game will end up being stumbling, perhaps dramatically.
Nonetheless, many will claim that besting the 10-year TIPS yield presents a minimal challenge. Perhaps, although beating this benchmark may not be the cakewalk it appears to be. Consider the outlook five years ago. The 10-year TIPS yield was 2.43% at the close of trading on September 2, 2003. Did that yield represent a muscular yardstick? It was easy to think not. Indeed, a conventional 10-year Treasury yield at the time was 4.61%, or nearly twice the TIPS yield. Keep in mind that the inflation outlook at the time was fairly modest. CPI was up just 2.2% for the year through August 2003, and expectations for anything materially higher were a rarity.
But five years later, the conventional 10-year's yield-inferred return doesn't look encouraging. CPI's rise over the past five years through July 2008 has averaged 3.65% a year. Deducting that inflation rate from the 10-year's 4.61% yield of five years ago leaves a real yield of just under 1% these days. In short, the 2.43% real yield of TIPS now looks far more enticing than many thought back in 2003.
Clearly, one's inflation expectations are critical for weighing the investment options of the moment. The exception is when choosing TIPS. Inflation may soar into the stratosphere, or tumble into deflation, but when you buy an inflation-indexed Treasury you lock in the current real yield. Come hell or high water, you'll receive that real yield.
That leaves the question of whether the 1.69% real yield that currently profiles the 10-year TIPS will suffice. It certainly looks low relative to recent history. Perhaps that inspires you to think that equities, commodities, REITs or other investments will fare better over the next 10 years. Or, maybe a diversified portfolio of several asset classes is the prudent choice, a strategy your editor tends to favor for the long run.
In truth, no one knows the answer. But our analysis must start somewhere, and the 10-year TIPS is arguably the first step for assessing what's available for everyone, no questions asked. In a world of risks, unknown and known, the first investment decision is uncomplicated: should we accept or reject the government's 10-year real yield? Question two, by contrast, is infinitely more complex.