TIPS Appear Relatively Cheap Right Now

(MoneyWatch)  Yesterday, we discussed the advantages that TIPS have over nominal return bonds for hedging both inflation and deflation. Today, I want to show why TIPS now look especially attractive relative to nominal Treasury bonds.

As I write this, the yields on five-year and 10-year Treasury bonds are 1.38 percent and 2.54 percent, respectively, while the yields on five-year and 10-year TIPS are 0.11 percent and 0.98 percent. Subtracting the TIPS yields from the nominal Treasury yields produces break-even inflation rates of 1.27 and 1.56 percent, respectively. Yet, the Philadelphia Federal Reserve's consensus forecasts of professional economists are at 2.00 percent (2010-2014) and 2.30 percent (2010-2019), respectively. Thus, we can conclude that TIPS look relatively cheap compared to nominal Treasury bonds, providing increased incentive to favor them.

The same comparisons can be made when considering investing in FDIC-insured CDs.

The investors who should prefer nominal bonds are those for whom future liabilities are nominal (not linked to inflation). For example, some corporate pension plans are not linked to inflation, but have defined obligations.

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