Last Updated Jul 21, 2009 11:05 AM EDT
Let's start with the breakeven inflation rate for TIPS and nominal bonds. As of Friday, the nominal yield on a 10-year Treasury note was 3.64 percent, and the yield on a 10-year TIPS was 1.78 percent. Thus, the breakeven inflation rate is 1.86 percent.
Now, let's compare that rate with the 10-year inflation forecast from a survey of professional forecasters provided by the Federal Reserve Bank of Philadelphia. The current 10-year inflation forecast is 2.5 percent. This is 0.64 percent above the breakeven rate.
It may seem like there's a negative risk premium for unexpected inflation, since the breakeven inflation rate is below the consensus inflation forecast. However, this isn't actually the case. TIPS contain an illiquidity premium because they are less liquid than nominal bonds. This means that if you have no need for liquidity, you're receiving an additional yield of 0.64 percent.
The same is true for 20-year instruments. As of Friday, the yield on nominal 20-Year Treasury bonds was 4.51, while the TIPS yield was 2.32. Thus, the breakeven inflation rate is 2.19, or 0.31 below the long-term inflation forecast, making the 20-year TIPS a compelling buy relative to the nominal 20-year Treasury bond.
If you're trying to choose between the 10-year TIPS or the 20-year TIPS, consider that since 1998 the real yield on 10-year TIPS has averaged about 2.0 percent while the real yield on 20-year TIPS has averaged about 2.2 percent. Thus, while the current yield on 10-year TIPS is 0.22 below its average, the current yield on 20-year TIPS is 0.12 above its average.
In addition, from 1926 through 2008, the real yield on nominal 10-year bonds averaged 2.55 percent, while the real yield on the 20-year averaged 2.69 percent. Thus, while the current yield on 10-year TIPS is 0.77 below the long-term average real return on nominal bonds, the 20-year TIPS yield is just 0.37 below the long-term average real yield on nominal bonds.
The bottom line is that TIPS are a compelling choice for the fixed income part of your portfolio and that the 20-year TIPS appears to be a more attractive alternative, not only relative to nominal bonds, but also relative to the 10-year TIPS.