TIPS Update: 15 Years Appears to Be the Sweet Spot
My last update on TIPS was February 24, so I thought it worthwhile to provide an update. I'll try to do this each month.
Current and Historical Data
The first table provides the historical data on the real return of nominal bonds from 1926 through February 2010. (Please note that the March CPI hasn't been released yet. That's why the numbers are through February.) The second table shows both the mean TIPS yield and the percentage of time since 1997 that the TIPS yield has been above the mean.
|
Historical Returns (%) 1926-February 2010 |
|||||
|
Five Years |
10 Years |
20 Years |
|||
|
Nominal |
Real |
Nominal |
Real |
Nominal |
Real |
|
5.35 |
2.27 |
5.38 |
2.30 |
5.46 |
2.38 |
|
Current Yields and Mean Yield (%) 1997-March 2010* |
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|
Five Years |
10 Years |
20 Years |
|
| Mean Yield |
2.23 |
2.67 |
2.18** |
| Current Yield |
0.39 |
1.57 |
2.10 |
| Current as % of Mean |
17% |
59% |
96% |
| Current as % of Historical Real Return |
17% |
68% |
88% |
* Yields as of March 31, 2010.
** 20-year mean yields begin in July 2004.
Our starting point for analyzing TIPS is the inflation estimate from the Philadelphia Federal Reserve -- 2.4 percent over the next 10 years. With current 10- and 20-year nominal Treasuries yielding about 3.8 and 4.5 percent, respectively, the break-even inflation rates are about 1.4 percent for the 10-year and 2.1 percent for the 20-year. With the 10-year TIPS yield above the break-even rate, and with 20-year TIPS at the break-even rate, TIPS should be the clear choice over nominal Treasuries, since there's no risk premium for unexpected inflation. When was the last time you got to buy insurance and not pay a premium?We also need to consider that current TIPS yields are below the long-term average real yield of both nominal bonds and TIPS. But because the TIPS yield curve is steep, longer-maturity TIPS are yielding much higher percentages of both the historic real return on nominal bonds of the same maturity and the historical yield on TIPS.
Note that by moving from five to 10 years, TIPS investors pick up an additional 118 basis points in yield or about 24 basis points a year. With the 15-year TIPS yielding 1.99 percent, investors earn another 42 basis points (or about eight basis points per year) by extending another five years. However, going beyond that only earns investors about three basis points a year.
Remember 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, there's no risk of loss if you hold to maturity.
Summarizing, it seems prudent to limit maturities to about 15 years (the current sweet spot), since absolute yields are still 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 equity allocation, thereby reducing the risk of the overall portfolio without lowering expected returns.