We receive many comments about the suitability of Treasury Inflation Protected Securities (TIPS) for client portfolios. As some of you have noticed (and others have called to discuss), you won’t find any TIPS in our holdings for clients. What gives? After all, the name alone implies a wealth of protection that surely is appropriate for a conservative investor like us, and the concept is an appealing one: a US government, credit-risk-free security that pays the owner more the more inflation there is. The government keeps track of the inflation rate while you own the bond, and at maturity you get whatever the $1000 face value has grown to. What can go wrong?
It should surprise no one that things can go wrong with any type of investment, even TIPS. Perhaps the most overlooked factor for the general investing public is the dynamic between actual inflation measured by CPI and the market’s expectations of future inflation. Both affect the value of TIPS, but what you and I expect to happen with respect to inflation may or may not come to pass. Grasp this and you start to see how TIPS can start to get a bit slippery despite their promises.
If we look at the 30 year TIPS that was recently issued at the end of February we see that it is paying a stated interest rate (coupon rate) of 0.625% and is trading at a slight discount to yield 0.63%. Clearly, a bit more than half a percent interest for 30 years is a terrible investment — unless you expect to have the value of your bond go up along the way, too. After all, you can buy a regular 30 year treasury bond that pays you interest of 3.21%. Given these two choices, you can start to see that if the TIPS bond goes up in value 2.59% each year in addition to its 0.625% coupon rate you get the same rate as the “regular” 30 year treasury (2.59% + 0.63% = 3.22%). If that’s exactly what happens, then you don’t really care which one you own over the 30 years, because they both got you 3.22% (wahoo!). This difference is what is known as the breakeven rate, and it moves around as inflation expectations change. If you just bought a 30-year TIPS and inflation expectations change, you can start to see how things may not necessarily end well.
The chart below shows the breakeven rate for 30 year TIPS over the past handful of years. Over the past 5 years the average breakeven rate was 2.29%, but it was as low as 0.71% and as high as 2.79%. Presented this way, it starts to become clear(er) that TIPS can be expensive or cheap at times. In November 2008, did people really expect inflation to average LESS than 0.71% for the next 30 years? That’s what you’d have to assume to be a seller of TIPS back then. How about just two and a half years later when you had to assume inflation would average 2.79% for the next 30 years in order to make TIPS seem like a bargain? That’s a harder question.
If there’s a good time to buy TIPS based upon breakeven rates, unfortunately that’s not enough data to make a fully-informed decision. Remember: TIPS are treasury bonds that pay some regular interest AND and an inflation adjustment. That means the price of regular treasury bonds also influences TIPS prices. The graph below adds the price of the 30 year TIPS issued in January 2008. And sure enough, when inflation expectations reached lows near the end of 2008, the price of TIPS was similarly low. But were increases in inflation expectations & the breakeven rate matched by corresponding increases in the price of TIPS? Not always.
Sometimes the price of TIPS and the breakeven rate moved in unison. Sometimes they moved in opposite directions. Sometimes one moved and the other didn’t. In the end, if the graph above is confusing, then our work here is done. The real take-away we want to leave you with is the complexity of TIPS and the mis-placed view many have of TIPS as a safe & easy way to hedge against inflation. Can TIPS protect against inflation? You bet. Can you over-pay for that protection? Absolutely. Either way, the market for TIPS is highly complex and not for the do-it-yourself crowd.