Yes, You Should Buy TIPS; Here's How and When

| About: iShares TIPS (TIP)

With much current concern about inflation due in particular to the sharp rise in basic commodities, investors are once again looking to add TIPS to their portfolios as a hedge against inflation. Yet there still persists much confusion about how, when, and why to buy TIPS.

Much of the confusion, in my view, comes from the lack of a fundamental understanding of the role of TIPS in the portfolio. And some of that confusion was evident in a recent article by Professor Jeremy Siegel of Wharton School in The Financial Times.

He argues that real rates on TIPS are historically low, inflation will go up along with economic growth, real interest rates will increase, and those who purchase TIPS at current levels will experience losses:

As economic growth recovers and real rates rise, the price of TIPS will fall leaving TIPS investors with large losses in the face of accelerating inflation.

His advice? Own stocks instead:

Even when these securities yielded 4 per cent, this yield did not compare to the historical return on equities, which has averaged between 6 per cent and 7 per cent in the US ….. Dividend-paying stocks, whose payment is well covered by earnings, should be the choice of the conservative investor. These stocks have not only offered inflation protection but have participated in economic growth. This strategy will give investors far better long-term protection against inflation than today’s low-yielding inflation-linked bonds

This means that TIPS investors should beware. Although TIPS may compensate holders for future inflation, the interest rate that they offer is far too low to offset the risk of rising rates.

A number of misconceptions underlie Professor Siegel’s analysis:

  • To begin with, his data is a bit faulty. As can be seen from the graph below (click to enlarge), the real yield on TIPS in recent years has been far below the close to 4% level he cites as a benchmark.

  • Furthermore, since TIPS guarantee a real return (nominal return – inflation), the appropriate comparison should be to T-bills whose interest rates would adjust rapidly to inflation rates. T-bills have averaged a real return of 1% with quite a bit of variation.
  • Most important, the Professor is looking at the wrong data point. The relevant figure in comparing TIPS vs. the true alternative is Treasury bonds of the same maturity rather than stocks which are a completely different instrument in terms of risk and return.
  • The real yield on TIPS is set by the market looking at break-even rates. That is the yield on nominal Treasuries vs. the yield on TIPS of the same maturity. If the investor expects inflation to exceed the break-even rate, TIPS are preferable because they will yield a higher real return (and vice versa). In fact, since the TIPS have zero risk of negative real return I would argue investors should be willing to accept a slightly lower implied break-even rate.
  • Therefore, in the current market, the real yield on TIPS may appear low because the level of nominal interest rates is low. But the relevant variable is the break-even rate.
  • We do have some history on the break-even rate. As reported in Investment News, Bloomberg calculates that the break-even rate has averaged .48% below inflation. In other words, on average the TIPS market underestimated inflation and buyers of TIPS made out better than investors in Treasuries.

The WSJ on Feb 24 had an article on inflation expectations. It included the graph below (), which includes historical break-even rates (the dark line in the graph, unfortunately the shortest data set since the TIPS started in 1998).

The Current Environment in the TIPS Market

Understanding the importance of the break-even rate leads one to evaluate the TIPS market differently than Professor Siegel and to reach some different conclusions. The current yield curve for nominal and real yields (as well as pre crisis data from Sep 2008 ) is below ():

As can be seen from the graph, the market is characterized by:

  • Low nominal yields : conventional 10 year yield = 3.48%
  • Low real yields: 10 year TIP =1.11%
  • But...the break-even rate is not historically low at 2.37% (check the graph above). As the Investment News article notes:

    Break-even rates advanced Jan. 5 to within 21 basis points of the 263 level reached in July 2008 when oil touched a record $147.27 a barrel and as consumer prices rose 5.6%, the highest level since 1990. Crude was down to about $86 last week. The break-even rate exceeded the CPI by as much as 132 basis points

So with the break-even rates in a reasonable range, but the real yields on TIPS low, what is an investor to do? And no, buying stocks is not the alternative. After all, if the real yield on TIPS goes up, the price of existing bonds (and TIPS ETFs) will go down.

A couple of answers:

  • Those extremely concerned about a near term spike in inflation should consider buying short term TIPS or the short term TIPS ETF (NYSEARCA:STPZ). The real yield is extremely low but it is almost a pure play on inflation. Should inflation spike, they may have a chance to extend maturities with higher real yields at that point when both real and nominal yields rise. In any case they have less price risk than in longer term TIPS.
  • The sweet spot in terms of risk and return on TIPS is probably at the same maturity/duration as in conventional bonds around 5 years. Buy and hold investors building positions at real yields above 1.5 -1.75% will on balance do well relative to Treasuries by purchasing TIPS in those maturities (or the ETF TIP) at those yields.
  • A long term buy and hold investor who purchased 20 year TIPS as part of his portfolio when real yields were around 2.25% would likely do well relative to the long term real return on Treasuries. The real long term return on nominal bonds has been 2.2% with far more price risk and of course the risk of negative real returns.
  • Laddering either through a mix of ETFs (STPZ short, TIP intermediate, and LTPZ long) or bonds is a reasonable alternative.
  • An interesting and more sophisticated strategy: Looking at the current market; the break-even rates are reasonable but the overall level of nominal interest rates is quite low. So it is possible that nominal rates could go up and real rates would go up as well simply to keep the break-even rate constant. That is a risk that can be hedged. Here is an example:

+ Purchase 10 year TIPS

+ Purchase 10 Year Interest Rate (NASDAQ:DTYS) Bear ETN

This locks in the break-even rate. If nominal Treasuries go up in yield, the hedge will go up in value, offsetting changes in the value of the TIPS if those yields rise at the same time.

In my view TIPS always belong in the fixed income part of the portfolio. And since the goal of the fixed income portfolio is to provide a real return at minimal risk, the question is how best to buy TIPS, not whether it is time to abandon TIPS and hold equities instead.

Inflation fighter wrote a nice critique of Siegel. As you can see, I share most of his views.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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