Last Updated May 18, 2011 11:58 AM EDT
If you're unfamiliar with TIPS, these bonds provide a guaranteed real (inflation-adjusted) return, insulating investors from the risks of unexpected inflation. Because nominal bond yields contain a risk premium for unexpected inflation, the Treasury should theoretically save the cost of the premium when issuing TIPS (which was the original rational for issuing them).
However, there's another factor in pricing that must be considered -- liquidity. The market pays a premium for liquidity. Nominal Treasury bonds are the most liquid investments in the world. Any other fixed income investment, even one of equal credit risk, will require a liquidity premium. The liquidity premium in TIPS could offset the advantages to the Treasury of avoiding the inflation insurance premium contained in nominal bonds. (Note that the flip side is that investors would be earning the liquidity premium, making TIPS especially attractive to investors who don't need liquidity.)
When TIPS were first issued in 1997, the liquidity premium was quite large. This might have partly been attributed to a lack of familiarity with TIPS. The TIPS market has developed considerably since then, and the liquidity premium has fallen. However, it rose temporarily, but dramatically, during the financial crisis. (Note that the Treasury can simply suspend the issuance of TIPS during a liquidity crisis to avoid paying a large liquidity premium).
The presence of a liquidity premium is causing a debate about whether the Treasury actually benefits from TIPS' issuance. The 2010 paper, "Why Does The Treasury Issue TIPS?" concluded TIPS issuance was costly to the Treasury. However, a new paper by the Federal Reserve Bank of San Francisco, "Has the Treasury Benefited from Issuing TIPS?" came to the opposite conclusion, noting that evidence shows that "the TIPS inflation risk premium has been large enough in recent years to offset the liquidity disadvantage of the series. This suggests that overall the Treasury has benefited from issuing TIPS."
My own view sides with the San Francisco Fed. The maturation of the TIPS market likely means both investors and the Treasury benefit from the issuance of TIPS. The liquidity premium will likely continue to shrink (thus lowering costs), due to two factors:
- TIPS liquidity continues to improve with each new issuance.
- More investors become familiar with the benefits of TIPS.
At the same time, investors can also benefit. TIPS might have lower expected returns than nominal bonds of similar maturity due to the presence of the risk premium for unexpected inflation that is part of the nominal bond yield. However, investors in TIPS aren't only obtaining insurance against unexpected inflation (which has negative implications for equities), but they can also extend the maturity of their bond holdings, earning the term premium (if the yield curve is upward sloping) without taking the inflation risk inherent in nominal bonds. And, the term premium is now far larger than any likely risk premium for unexpected inflation less any liquidity premium. For example, as of April 28, 2011:
- Five-year TIPS are currently yielding about -0.4 percent.
- 10-year TIPS are yielding 0.8 percent.
- 20-year TIPS are yielding 1.5 percent.
- 30-year TIPS are yielding 1.8 percent.
More on MoneyWatch:
TIPS Update for April 2011 What to Consider When Buying TIPS How to Guard Against Inflation Through TIPS Interest Rates: Why Waiting for Rates to Rise May Cost You Are Stocks Overvalued?
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