7 Reasons 'Inflation-Protected' Bonds Aren't

Includes: GTIP, ITIP, TIP
by: Dollar Skeptic

Given turmoil in the markets and increasingly bearish sentiment, institutional and retail investors are moving from what they perceive to be risky investments to those they perceive to be safe havens. As investors, we spend a lot of time analyzing whether we have the appetite for a given investment's risks, given its projected returns. Some risks are easy to manage, others are hard to even identify. We must always look with a critical eye at own assumptions and those of others in order to identify and control for misleading data and uncover the truth as best we can.

One of the types of investments that come up for discussion in today's bearish climate are "Inflation-Protected" Bonds. There are two kinds, I-Bonds and TIPS. As risk managers, either professionally or for our own retirement accounts, we need to ask ourselves what they really protect against, how much protection they offer, and identify the hidden risks lurking below the surface.

I Bonds aren't worth spending long discussing - purchase limits are very low, they can't be sold on secondary markets, and they have low liquidity because you must hold I-Bonds for at least 12 months before cashing out. If you cash out before owning the bonds five years, you lose three months' worth of interest.

TIPS, on the other hand, do have a secondary market, numerous ETFs and mutual funds own them, and they purport to adjust for inflation. They are also available for direct purchase from the Treasury and pay semi-annual interest to the holder, so are sometimes seen as a safe way to provide retirement income. As a result, more people are looking at them as a potential way to preserve their savings in an inflationary environment.

TreasuryDirect describes TIPS bonds as follows:

Treasury Inflation-Protected Securities (OTC:TIPS) are marketable securities whose principal is adjusted by changes in the Consumer Price Index. With inflation (a rise in the index), the principal increases. With a deflation (a drop in the index), the principal decreases.

The relationship between TIPS and the Consumer Price Index affects both the sum you are paid when your TIPS matures and the amount of interest that a TIPS pays you every six months. TIPS pay interest at a fixed rate. Because the rate is applied to the adjusted principal, however, interest payments can vary in amount from one period to the next. If inflation occurs, the interest payment increases. In the event of deflation, the interest payment decreases.

At the maturity of a TIPS, you receive the adjusted principal or the original principal, whichever is greater. This provision protects you against deflation.

On paper, they sounds good. However, an analysis of the features of TIPS indicates that they do not meet their stated objectives, and instead carry numerous significant risks which the Treasury does not disclose to potential buyers:

1. There's no such thing as a free lunch.

And there is no such thing a risk-free investment. If you think TIPS or any other investment are risk-free, don't own them: It's a bad idea to own securities one doesn't understand.

US government debt now exceeds the GDP and future liabilities are much higher. The interest rates for these bonds are way too low for the level of sovereign risk.

If you own a fund that owns bonds instead of directly owning the notes, the solvency of the institution that owns it is a significant risk, on top of the sovereign risk.

2. Inflation-protected bonds don't protect you from inflation.

The premise of TIPS are that they increase their yield to match inflation. However, they are indexed by CPI, which does not accurately track inflation. The government has every incentive to under-report inflation as it hides their monetary expansion and lowers their spending commitments for all Treasury bonds including TIPS, Social Security Cost of Living Adjustments, and more. The best lipstick you can put on this would be that CPI metric isn't a scam, it's just inaccurate due to the BLS incompetence. I don't see how in practice that's any better.

There are lots of other people who have documented specifically how CPI in its various incarnations is a fraudulent statistic; there's no need for me to rehash the arguments in depth. In summary, the government has changed the way they calculate CPI over time. This change has not been for the better, if by better you mean accurate. To see how this data looked using the way inflation was calculated until 1980 and the divergence over time due to post-1980 use of substitution and hedonics, see Shadowstats.

Bloomberg, echoing the BLS, calls the idea that the CPI is cooked a "conspiracy theory." However, given means, motive, ability, and evidence, I consider it a conspiracy fact. As I discussed on the Dollar Skeptic blog in the recent past, European central bankers have already admitted that when the going gets rough, they lie. I am under no illusion that American central bankers are fundamentally different.

The BLS wrote a rebuttal of sorts, yet admit that CPI is not really a cost of living index, even though it is used to adjust COLA.

Reason explains why anyone would even want to buy Treasury bonds at this point - the US is essentially a good house in a bad neighborhood.

3. Bond prices are manipulated by the Federal Reserve.

The government manipulates bond prices heavily. The Federal Reserve program called Operation Twist, which continues unabated, has pushed down short-term yields to increase long-term yields, trying to push investors into equities such as stocks and corporate bonds, and real estate.

The Federal Reserve is also pushing down <10 year yields in order to drive people into longer term notes which the Federal Reserve can pay back with cheaper dollars later, or into equities and real estate. TIPS bonds all pay negative yield curve rates, unless you buy a 20- or 30-year note from the Treasury, not secondary markets. Yields are negative for anything less than a 10-year TIPS bond.

It's evidence of their strategy to essentially steal from bond buyers: The spread between the real inflation rate and CPI, used to calculate the value of your bond, is the return they pocket at the expense of the bondholder.

As a result, if you buy 10-year or shorter term TIPS, you will not earn enough interest to make up for the declining value of the bond due to the misstatement of CPI in the short term. If you buy a longer term bond, your loss is only limited by the extent of downward manipulation of CPI over the next 10, 20, or 30 years.

4. The Tax Man

If you don't hold TIPS in a tax-deferred account, you will be taxed you ordinary income rates for the semiannual interest payments you receive and for the "phantom income" you receive as your underlying principal adjusts for inflation. You don't receive this inflated principal until the bond is redeemed, but you will be paying tax on the adjustments annually and could be paying taxes on gains you haven't even actually seen, above and beyond the amount of interest you're paid, assuming you bought a 20- to 30-year note. For notes that mature in 10 years or less, this is all but guaranteed.

5. Bond bubble: TIPS are not an inflation hedge.

Bond prices and yields are inversely correlated: Low yields are coupled with high bond prices. Many people have called a bond bubble as investors move into what they perceive to be lower-risk assets. If you sell TIPS before maturity, you'll take a loss if you sell on the wrong side of a popped bond bubble. Even worse, there is a $45 transaction fee to sell before maturity.

One argument used against the bubble theory is that a bubble can only happen when demand outstrips supply, but my opinion is that this only applies to assets whose supply has constraints relatively stronger than "how many certificates to print, this month?"

TIPS are promoted as a cheap inflation hedge, but clearly aren't. They are also purportedly not tied to the return of other investments, but this is provably false.

TIPS today say to us: If you want to lock up your money for up to 10 years with no possibility of default, you must accept a slightly negative real rate of return. Maybe more than slightly, depending on how cooked the CPI numbers really are.

If TIPS are popular, that implies investors don't think even riskier assets have more than 1% greater or so real rate of return.

TIPS payoffs might seem to look the best in an inflationary scenario, but that is when the government can least afford to pay them off and is most likely to default. If the government keeps inflation very low, there is almost no return. If inflation gets out of control, not only do does real inflation shoot past CPI, but the government is likely to default, and you won't even get your initial investment back. Greece is in this situation now, having to decide whether to pay bond holders or pensioners.

Given that the US exports much of its inflation, if dollars continue to be seen as a safe haven, those dollars will return to our shores as investments in the US economy, causing rapid inflation. (At least we still export something.) The quantity of goods available doesn't increase, just the quantity of dollars. This will reduce the spending power of existing dollars, destroying the value of savings in dollar-denominated assets and dollars.

Supporters of the Federal Reserve might argue that the effect would be prosperity for the US, since the US becomes a single port of commerce and trade. In rebuttal, I offer that our manufacturing sector has eroded, and by and large, we don't manufacture the kinds of things here that the rest of the world wants, save for weapons exports. Unless you believe that breaking windows leads to economic growth, this does not improve the economy.

Instead, essentially anything of value in the US becomes an exportable product. This is already happening - one example is soaring prices for scrap metal. This has led to an epidemic of metal theft, which is happening all over the world, not just in the US. It's only a matter of time before this sector of the "export economy" moves from stealing manhole covers to strapped consumers pulling copper wiring and plumbing out of their own houses, and hauling it to the scrap yard for cash. I'm happy to not have an example to point you to for that scenario, yet. The only "hope" would be that as global economic slowdown cools demand, this would moderate the effect of dollar devaluation and increasing prices.

Buying inflation protection from the government is like buying credit default protection on JPMorgan from JPMorgan.

6. Bonds are essentially a Ponzi-like scheme

Taking the previous points into account, we can determine that the primary reason TIPS exist are to provide an excuse for the US Government to issue bonds with crappy coupons and pay off earlier bondholders with more borrowed money, in a Ponzi-like scheme.

7. Treasury bonds are only a good investment in two unlikely scenarios

1. If you can buy them at a significant discount, are comfortable with the sovereign risk, and the taxes on interest payments won't kill you before the government defaults and you lose your initial investment.

2. If you don't care about bond returns because you are another large country that wants to use them as a diplomatic club.

The only money to be made is in trading TIPS bonds, not holding them. Theoretically. I can't help you with that, though - while I understand them well enough to know they won't protect my savings against inflation, I don't have any idea how to trade them profitably.

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