TIPS Update for December

I thought it especially important to provide an update on TIPS now, given the continued sharp rise in yields over the past several weeks.

Current and Historical Data The first table provides the historical data on the real return of nominal bonds from 1926 through October. 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. The current yields are as of the close of Dec. 9.

Table 1: Historical Returns (%) 1926 -- October 2010

Table 2: Current Yields and Mean Yield (%) 1997 -- Present

* 20-year mean yields begin in July 2004.

The 10-year and 20-year nominal Treasuries are currently yielding about 3.2 percent and 4.2 percent, respectively, (increases of about 0.5 percent and 0.4 percent in the last month). The break-even inflation rates are about 2.2 percent for the 10-year and 2.5 percent for the 20-year.

Given that the inflation estimate from the Philadelphia Federal Reserve is 2.2 percent over the next 10 years, there's no risk premium for unexpected inflation on 10-year nominals. On the 20-year TIPS, the risk premium is still a relatively small 0.3 percent. Thus, while TIPS yields are at historically low levels, TIPS continue to look like a clear choice over nominal Treasuries in relative terms, especially for 10-year TIPS.

The same is true of the five-year TIPS. The five-year nominal Treasury is yielding about 2.1 percent (up 0.8 in the last month), and the Philly Fed's five-year inflation forecast is 2.0 percent. Thus, the nominal five-year Treasury has an expected return of 0.1 percent, virtually the same as the TIPS yield. Once again, we see that you're getting inflation insurance without an insurance premium.

There's another point to consider. Current TIPS yields are well below the long-term average real yield of both nominal bonds and TIPS, but the steepness of the TIPS yield curve means longer-maturity TIPS are yielding higher percentages of both the historic real return on nominal bonds of the same maturity and the historical yield on TIPS. You pick up an additional 96 basis points in yield (or about 19 basis points a year) by moving from five years to 10 years. Another five years gives you about another 11 basis points per year. However, going beyond that only earns you about three basis points a year. And with real yields still well below their historic averages for TIPS, you may not want to extend maturities much further than 15 years.

As always, one last 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, there's no risk of loss if you hold to maturity.

Summarizing, it still seems prudent to limit maturities to about 15 years, 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.

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Hear Larry Swedroe discuss current investment trends and topics every Sunday at noon on 550 AM KTRS in St. Louis or streaming via the KTRS Web site. Can't catch the show? Download the podcast via www.investmentadvisornow.com or through the Buckingham Asset Management podcast page on iTunes.