Why You Should Own TIPS

Includes: ILB, TIP
by: Vipin Sahijwani

The financial press and the investment pundits have put considerable effort into downplaying the attractiveness of inflation linked bonds such as TIPS. The argument against owning them is based on low or negative yields. In my opinion, the argument misses the point; yields today are low for all bonds and the fact that there are negative yields on TIPS today is not a reason to run from them. No analysis of inflation protected securities is complete without doing a break-even analysis, which is the difference between the yield on nominal bonds and inflation protected securities of the same maturity and by the same issuer. For example, the difference in yield between the 10-year Nominal Treasury bond and the 10-year Treasury Inflation Protected Securities is approximately 2.4%. This is called the implied break-even point, which means that if you believe inflation will exceed 2.4% on an annualized basis over the next 10 years, you will be better off holding TIPS rather than nominal Treasury bonds. Global treasuries will underperform Global Inflation Linked Bonds in any scenario in which inflation heats up even slightly. Inflation does not need to be hyper-inflation for an investor to make money; as long as inflation is higher than the implied rate of 2.4%, an investor will be better off holding TIPS.

Let us take our analysis a step further and compare investing in nominal Treasury bonds versus investing in TIPS of same maturity by analyzing bond risks in various possible scenarios.

Duration Risk:

TIPS duration is higher than nominal bonds of the same maturity as TIPS pay a lower coupon, but given the generally positive convexity of bonds, the duration differences are mitigated.

Credit Risk:

Both Inflation linked bonds and nominal bonds carry the same credit risk assuming the same issuer.

Scenario Analysis:

a) Rates go up and inflation goes up.

In this scenario, it is likely that TIPS will outperform nominal Treasury bonds as the interest rate sensitivity will be more than mitigated by the rise in the principal payment, due to higher inflation.

b) Rates go down and inflation goes down.

This is an unlikely scenario given the current low rate environment, but not improbable as rates do have room to further decline. In this scenario, nominal Treasury securities will outperform TIPS.

c) Rates stay low and inflation goes up.

This is the scenario the Federal Reserve is targeting, and is also most likely, in my opinion, if the US is to survive the debt crisis. In this scenario, inflation linked bonds will outperform nominal Treasury bonds significantly.

Investing in inflation linked bonds can be a good compliment for a nominal bond allocation. I always recommend adopting a global approach to investing in inflation linked bonds (also called Linkers) as liquidity or quantitative easing in one country typically generates inflation pressures in other countries. My investment vehicle here is PIMCO's Global Inflation Linked Bond ETF (ILB). ILB is a better choice than iShares Treasury Inflation Protected Securities ETF (TIP), which is focused on the U.S. domestic market. In my opinion, borrowing terminology from Nassim Taleb, investing in inflation linked bonds is an "Antifragile" investment that can gain from disorder, while having limited downside.

Disclosure: I am long ILB. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.