Lawrence Weinman's  Instablog

Much of the confusion in my view comes from a lack of a fundamental understanding of the role of TIPs in the portfolio.

A fundamental principle of portfolio construction is that portfolios should contain a mix of risky assets and a risk free asset with the proportion of the risk free asset increased or decreased according to the investor’s risk tolerance. While in the classic construct of portfolio theory  the risky asset was represented by the US market (S+P 500) let’s broaden the category to include everything except US $ Treasury bills.

Tbills are generally regarded as the risk free asset which guarantee return of principal at maturity (living in a world where investors believe there is zero risk of a US government default) and have minimal interest rate risk due to their extremely short maturity.

There is a another risk for fixed income investors which is negative real return. This occurs when the interest rate earned is smaller than inflation. The investor receives back his principal and interest but the interest has not compensated him for inflation. The nominal return (interest rate) is positive but the real retur (interest rate – inflation rate ) is negative. The assumption is that Tbill investors

will always demand a positive real return and that the market rates for Tbills will adjust with inflation. Thus each time the investor rolls over his Tbills at maturity he will receive  new rate which will give a positive real return

But note that there is no guarantee what that Tbills will always  produce a positive real return. Over a long period of buying and rolling over short term Tbillls the real return is uncertain and has that real return has varied widely over history.  Also, of all the interest rates in the market place short term rates are most directly impacted by the actions of the Federal Reserve.  The Tbill investor is likely to receive a positive real return but has no idea what that real return will be.

Interestingly, the long term real return on Tbills in the US (1900-2010) averaged 1%  with a minimum of -15.1% and a maximum of 20%. 

Now consider TIPs. In my view they are an alternative risk free asset although of a different  type. A TIP offers a fixed real return that is added to the inflation rate (CPI-U) each time interest payments are calculated and paid. So the positive real return is not only a theoretical near certainty (as in the case of Tbills) it is guaranteed  and locked in for the TIP owner.  The TIP investor can never receive a negative real return and that real return will not fluctuate over the life of the bond. . As for credit risk,  like Tbills , the TIP carries the same US government credit risk  (although the money is locked in for a longer term).

Because the real return  is locked in I would argue that a TIP is actually more of a risk free investment than a Tbill : the investor has no credit risk (again assuming the full faith and credit of the US is not a credit risk) and has locked in his real return. In other words a true risk free asset looked at from the perspective of the investor that wants a risk free after inflation positive return and minimal risk of receiving his principal back. 

For the long term buy and hold investor looking for a risk free investment TIPs rather than Tbills  are just about the perfect investment. They carry (next to) no credit risk = guaranteed return of principal and no risk of negative real return.

Looking at that long term real return average of 1% for Tbills it would seem one could argue with some validity that a reasonable expectation for a real yield on TIPs might even be close to that level rather than comparing it the historical real return of longer term conventional Treasury bonds

But the above does not mean that one can all market conditions are the same for TIPs and that is where the confusion seems to begin.

Real interest rates on TIPs are not constant; they are set by the market. The market looks at “break-even rates”= the nominal rate on conventional Treasuries  - the real rate of TIPs of the same maturity.

To give an example from the current market

10 year nominal bond  3.48%

10 year TIP yield             1.11%

Break-even rate (nominal –TIP)  2.37% 

The difference between the two rates is the market’s estimate of future inflation. An investor that anticipates a higher rate on TIPS than the break-even would prefer the TIPs. For the investor with the opposite inflation forecast, the conventional bond would be the investment of choice. The real yield set by the market on the TIPs is not set completely in isolation it is linked by the hip to the level of nominal interest rates

This is where I think some of the confusion arises with regards to TIPs . Some investors think there is no market risk to TIPs. And many investors think that when fear of inflation is high the prices of TIPs(and TIP ETFS) will go up. In fact, the opposite can be the case. Just as with regular bonds prices and yields move in opposite directions.

The determining factor for TIP yields is the markets' inflation assumption and the break-even rate.  So changes in anticipated inflation can produce changes in the prices of seasoned TIPs (and etfs) that can be somewhat counterintuitive Iit is also crucial to understand that the prevailing real yield on the TIP is not in itself the markets forecast of inflation rates. If nominal interest rates are at a low level relative to historical rates and historical inflation, real yields on TIPs will be low.

Consider the following  scenarios

·        An increase in inflation expectations causes TIP yields to rise. This causes the price of outstanding TIPs (and TIP ETFs) to fall as they are unattractive relative to the newly issued TIPs.

·        As a consequence, inflation expectations fall, yields of newly issued TIPs fall and seasoned TIPs (and TIP ETFs) prices rise.

This can be seen in the graph below of performance of TIPs ETFs performance along with the conventional treasury ETF (IEF)  In the first part of 2010 inflation expectations fell, real yields on TIPS fell and the prices of seasoned TIPs (and TIP ETFs) rose. The exact opposite has occurred more recently. Interestingly both nominal bonds (IEF- conventional Treasury ETF in green) and TIPs  moved in the same direction (although equivalent maturity TIPs outperformed. Why? because inflation expectations  on both types of bonds drove changes yields and prices of seasoned bonds and ETFs..

(LTPZ longer term TIPS in black ,STPZ short term TIPs in yellow, TIP intermediate TIPs in blue, intermediate term conventional Treasury ETF IEF in green)

What does this mean for TIP investors ?

·        Just like nominal bonds longer term bonds change in price more in reaction to changes in yields than shorter term bonds. In the case of TIPs of course the price movement is in reaction to changes in real rates. Thus one can see in the graph above the short term TIP ETF  (STPZ) has smaller price fluctuations. The rate on short term TIPs is affected mainly by the actual inflation adjustment. The yield will be closest to the actual CPI. It is more of a pure play on actual inflation and less of a market assessment of future inflation over the lifetime of the bond. So certainly the shorter term TIPs are less risky in terms of price fluctuation than the longer term ones. They are close to a short term bond with guaranteed adjustment to the CPI.

Of course no risk no return and just like conventional bonds, TIPs have an upward shaped yield curve so the investor with short maturities gets a lower real yields

·         TIP investors willing to extend their maturities to pick up yield should look at the prevailing rates on TIPs, nominal bonds and future inflation. As a point of reference inflation over the period 2003 -2011  has  averaged 2.25%.  TIP yields have averaged .43% less than the CPI since 1998 meaning the market underestimated future inflation. Investors on average were better off with TIPs rather than conventional Treasuries.

·         Below are historical graphs of TIPs of various maturities for
 (the data available is fairly limited).

·        For longer term  buy and hold type investors the sweet spot in terms of risk vs. return is probably in the duration of  around 5 years, which in ETFs would point towards the TIP (4-6 year maturity TIPs)

The longer term investor probably wouldn't wind up with many mark to market losses when the real yield on this instrument is above the recent inflation average of 2.25 % or somewhere between the Fed’s long term target of 2.5- 3.0%.

Where the market stands now:

The graph below shows the somewhat paradoxical situation between real and nominal yields . The graph shows current yields and those in June 2008 prior to the financial crisis.




Currently 5 year TIPs carry a real yield of .28% (that is actually up from the end of last year ) and nominal  5 year Treasuries yield 2.30%. This means that the break-even rate is 2.02%  (nominal – TIPs) . Thus  the TIP is preferable if one expects inflation higher than that rate.  Even though the prevailing real yield is low relative to historical rates it still is likely more attractive than the conventional Treasury.  

It is not enough to simply look at the TIPs rate  in isolation because in this case it is the very low nominal rates on conventional Treasuries  that drive the TIPs rate so low. For 10 year rates nominal = 3.86 TIP = 1.25  break-even  = 2.61%., it was as low as 1.47% in August of last year.

  In the current market both real yields on treasuries are low and nominal rates on conventional Treasuries are low relative to historical inflation. But the market expectation of inflation as reflected in break-even rates has risen sharply.

Both real rates on TIPs and prospective real rates on nominal treasuries are low. But the break-even rate is not at all unreasonable and certainly points to TIPs as opposed to nominal treasuries. As a point of comparison the  highest CPI since the beginning of the TIPS market (1998)  was in  July of 2008 (oil was at $147). CPI hit 5.6% and the breakeven rate reached 2.63% . 

Professionals in the bond market who are involved in the market on an ongoing basis and are  focused on the break-even rate in setting prices and with nominal rates low, it is logical for real yields to be low as well. But the long term investor faced with the low real rates has a dilemma. I would suggest 3 responses:

1.     Holding short term TIPs  (or perhaps STPZ  the short term TIP) so that when real rates go up there will be minimal price fluctuations

3.    Averaging in or laddering.  Holding a mix of maturities of TIPs through ETFs ,bonds, or funds and staggering purchases close to 2% in yields minimizes risk.

Jeremy Siegel, a well know Finance Professor from the Wharton School of Business has given some pretty poor advice on TIPs in a recent article recommending investors avoid TIPs and hold stocks instead. That's bad advice TIPs always have a place in investor portfolios. More on that in the next article