For TIPS, limit maturities to 10 years

(MoneyWatch) I have updated the tables below on Treasury inflation-protected securities. The data is as of Nov. 15. The first table provides the historical data on the real return of "nominal" Treasury bonds from January 1926 through October 2012. The second table shows the current and mean TIPS yields.

In the past month, yields on five-year TIPS have risen by 0.09 percent, while 10-year and 20-year TIPS yields have fallen by 0.03 percent and 0.09 percent, respectively. The five-year TIPS yield is now -1.51 percent, the 10-year TIPS yield is now -0.83 percent, and the 20-year TIPS yield has fallen to -0.11 percent. With the exception of the TIPS maturing April 15, 2013 (which is yielding 0.37 percent), TIPS bonds out through 20 years are all at negative yields. Only the last three maturities -- February 2040, February 2041 and February 2042 -- offer positive real yields. Nominal treasuries have continued to also hold at low levels, with the five-year Treasury yielding 0.61 percent, the 10-year treasury yielding 1.58 percent, and the 20-year treasury yielding 2.23 percent.

The latest release from the Philadelphia Federal Reserve for the fourth-quarter inflation estimate was 2.30 percent over the next 10 years, down from the previous quarter's estimate of 2.35 percent. The risk premium for unexpected inflation (the difference between the headline CPI estimate from the Philadelphia Fed forecasters and the break-even rate between nominal Treasuries and TIPS) on 10-year nominal bonds was virtually unchanged, increasing from -0.11 percent to 0.12 percent over the past month. This means that the risk premium for unexpected inflation is slightly positive for the first time in a while. On the surface, this would slightly favor nominal Treasuries over TIPS. However, investors who are averse to the risks of unexpected inflation should still prefer TIPS over nominal Treasuries of the same maturity.

The Philadelphia Fed's fourth-quarter five-year inflation forecast is 2.28 percent. Five-year nominal Treasuries now yield 0.61 percent, which makes the expected real return -1.67 percent, a decrease of 0.04 percent from last month. The market break-even rate between Treasuries and TIPS for five years is 2.12 percent, which indicates that five-year TIPS are more attractive than nominal five-year Treasuries.

The TIPS curve continued to flatten over the past month. With real yields near their historic lows and the curve flattening due to demand for longer maturities, it makes it even more difficult to extend maturities. Currently, by extending from the five-year TIPS to 10-year TIPS, there's a 0.67 percent yield pick-up (or about 0.13 percent per year). Extending another five years gives you around 0.11 percent per year, and beyond that around 0.07 percent per year. Currently, to get positive real yields, investors would have to extend to the 2040 maturity (0.21 percent).

While TIPS yields don't look attractive relative to historical averages, you can't buy yesterday's yields, only today's. And since our crystal balls are always cloudy, we can't know if the current yield on longer-term TIPS will look good or bad 10 years or more in the future.

As always, one point to remember is that one of the advantages of TIPS over nominal bonds is that you can take maturity risk with TIPS and earn the term premium without taking inflation risk. Thus, while longer-term TIPS have more interim price risk -- which for some investors could be too much volatility to stomach -- there's no risk of loss if you hold to maturity.

The decision of when to purchase TIPS -- and when not to -- can be a confusing one. The most important factor is the need for inflation protection. If you're living off of your portfolio and/or have a fixed pension, that could indicate a situation where TIPS might be a significant part of the solution. For other cases, it's certainly not as clear, complicated by the fact the answer changes over time.

For example, CDs have currently yields that range from 0.5 percent to 0.8 percent higher than conventional Treasuries. From a held-to-maturity point of view, this means TIPS will underperform CDs of comparable maturities unless inflation ends up being significantly higher than it's expected to be. This is certainly not impossible, but it does cause additional thought for someone who may not need inflation protection. Worth noting is that the current state of affairs and spreads between various investment products does change and in instances where other investments are closer to Treasury yields, TIPS will be a more attractive solution relative to the other investment vehicle.

Summarizing, it still seems prudent to limit maturities to about 10 years or so, since absolute yields are well below levels that would make longer-term TIPS a compelling buy regardless of the shape of the yield curve. If real rates rise well above the historical averages, you should consider locking in the higher yields for as long as possible, regardless of the shape of the yield curve. Higher TIPS yields would provide the added benefit of allowing you to lower your stock allocation, thereby reducing the risk of the overall portfolio without lowering expected returns.

[LarryswedroeCBS]

CFP,EA
First, SV tends to do well in inflation as all value does and the reason is that value stocks tend to be more leveraged and inflation reduces real cost of debt. Check 70s for example. SV up 13.1 vs S&P 5.9

Second, I have a general strong preference for TIPS as explained in both my book on Alternative Investments and Bond book. And also my Only Guide for the Right Financial Plan

Third, while that strong preference is there, IMO rates on alternatives matter. So on short end currently CDs have much higher yields than nominal Treasuries, so the break even inflation rate is much higher, so the risk premium you are paying for TIPS is higher. Thus with the relatively low risk of ST nominals I would prefer them to ST TIPS for all but those who are highly exposed to inflation risk. On longer end would prefer TIPS if choice is longer nominals or longer TIPS.

But with very low level of real rates IMO it's worth at least considering shorter term with nominals (say 5 years or less) and then shifting to longer term TIPS if and when rates return to historical averages. I discuss this idea of a shifting maturity approach to TIPS in The Only Guide to Alternative Investments and in the bond book as well. Now with ST, intermediate and LT TIPS funds you can even do it with funds.

BTW-I am huge fan of the low beta/high tilt portfolios as the big benefit is cutting tail risk --the so-called Larry Portfolio that was highlighted in a NY Times article a while ago and is discussed in the Appendix to my book The Only Guide You'll Ever Need for the Right Financial Plan. It should helped during the 08 crash, limiting losses.I'm sure that all those who adopted the strategy have been happy with the results.

I hope that is helpful

Best wishes
Larry

[CFP, EA]

Larry,

As always, thanks for the reply.

On SV and inflation, I agree 100%. SV appears to handle inflation much better than growth due to higher debt levels. Also, given the higher dividend rate, they have a shorter duration, which always helps when inflation hits.

To be honest, I worry more about inflation than deflation. Not at this moment, but in a general portfolio design sense. Deflation is brutal for stocks and the economy as a whole, but there's a known anecdote: high quality bonds. In essence, there's a game plan to fight deflation.

Inflation is more tricky. (Also, I don't think most investors understand its danger.) Stocks don't do well. Nominal bonds - even treasuries - don't do well. Commodities can help, but, generally, you don't hold enough to make much of difference. Most people hold stocks and nominal bonds, both of which don't do well with inflation. That's why inflation haunts me. And that's why I love TIPs and SV.

Granted, at the moment, short-term CDs are a better option. But I was more talking about a general strategy (use TIPs for FI over the long run) rather than tactics (used ST CDs for part of FI and TIPs for longer maturity).

As I was alluding to before, I don't think that most investors understand the advantages of low beta/high tilt portfolio where you employ SV and TIPs (at least, TIPs when their rates are a bit more normal). It cuts off the tails. It protects against the big three (growth, inflation, deflation). And, finally, it provides for the same return as a typical portfolio heavily tilted toward S&P with nominal bonds, with dramatically less risk.

Yet, you never hear about such a portfolio design. It drives me crazy.

Thanks for letting me know that I'm not alone,

CFP, EA

Looks like I need to go back to some of your books and buy a few more so I can stop asking redundant questions.

[CFP, EA]

Larry,

Since your thinking of portfolio design seems fairly similar to mine - allbeit on different intellectual planes (hint: Larry's is a wee bit higher than mine) - I wondering if you could comment on my thinking of the role of TIPs.

Like you and other, I always think of individual assets in terms of how they relate to other assets and how the combination of various assets can create the optimal portfolio. And like everyone, I spend far too much time playing with numbers (I do love my DFA 2.0 and Ken French's database) investigating correlations and comparing performance of different combinations.

However, in the end, my simple goal is to prevent myself and my clients from getting too severely damaged by the usual economic situations: 1) Growth periods 2)Inflation and 3) Deflation.

For growth periods, small value is your man. It grows the most. That's its job. Performs terribly in deflation and poorly in inflation.

TIPs can handle inflation and deflation. (Granted, LT treasuries give a better pop in deflation but the price paid during inflationary periods is too high.) In addition, you can lengthen the duration of TIPs, which can offset some of their weakness in deflation.

I know from back-testing that a portfolio with TIPs outperforms a portfolio with intermediate treasuries. But putting that aside, using TIPs just makes sense theoretically. The carnage inflicted on LT Treasuries in an inflationary would be far higher than their outperformance of TIPs in a deflationary environment.

Assuming that you can put FI in tax-deferred accounts, shouldn't a solid portfolio plan look like this: 1. Reduce equity share by moving to SV (US-SV, Int-SV, EV) 2. FI goes to TIPs - maybe a 7-year ladder and 3. (optional since you could just sell short maturity TIPs) Keep maybe 10% in cash/ST Treasuries for quick rebalancing during steep equity falls.

You could add a bit to that - REITs and commodities - but a very simple SV/TIPs portfolio seems to provide very effective protection against severe economics situations and reasonable returns.

If that's the case, why doesn't everyone recommend 100% TIPs if FI can be held in tax-advantaged accounts? What am I missing?

Best,
CFP, EA

[LarryswedroeCBS]

CFP EA
Glad to help
I agree with your analysis. As I said, in general I much prefer TIPS for the reasons you point out adding that with TIPS you get the benefit of the term premium without any inflation risk that you have with nominals and the term premium. But we are now in anything but a normal interest rate environment. Doesn't mean it cannot last (see Japan), but don't like the risk/reward of long TIPS now and ST CDs better than ST TIPS IMO.

Best wishes
Larry