TIPS Update for February 2011

Before we launch into the current TIPS numbers, I wanted to show you an example of how to compare TIPS when choosing which one to purchase. Consider that:

• The January 2028 TIPS (with an inflation factor of 1.04) is yielding 1.92 percent.
• The April 2028 TIPS (with an inflation factor of 1.35) is yielding 1.98 percent.

(I should also note that we actually did experience 18 years of cumulative deflation [0.2 percent per year] beginning in 1926.)

Now, on to the numbers. After a quiet few months with relatively stable rates, TIPS yields have risen dramatically over the past few weeks, as have nominal yields.

Current and Historical Data The first table provides the historical data on the real return of nominal bonds from 1926 through December. 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 February 11.

Table 1: Historical Returns (%) 1926-December

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

The 10-year and 20-year nominal Treasuries are currently yielding about 3.6 percent and 4.5 percent, respectively. The break-even inflation rates are about 2.3 percent for the 10-year and 2.5 percent for the 20-year, virtually unchanged from last month.

Given that the inflation estimate from the Philadelphia Federal Reserve is 2.3 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 now 0.2 percent. Thus, while TIPS yields are at relatively low levels, TIPS continue to look like a clear choice over nominal Treasuries in relative terms, at least for 10-year TIPS.

The same is true of the five-year TIPS. The five-year nominal Treasury is yielding about 2.4 percent, and the Philadelphia Fed's five-year inflation forecast is 2.1 percent. Thus, the nominal five-year Treasury has an expected real return of 0.3 percent, just 0.04 percent more than the TIPS yield. Again, you're getting inflation insurance while "paying" very little insurance premium.

There's another point to consider. Even with the sharp rise in yields, TIPS yields are still well below the long-term average real yield of both nominal bonds and TIPS, at least until you get out very far on the curve. (The 20-year TIPS have yields that are finally approaching their longer term averages.) However, as has been the case for quite a while, the steepness of the TIPS yield curve means 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. Thus, there's a steep price to pay for keeping maturities short.

For example, you pick up an additional 106 basis points in yield (or about 21 basis points a year) by moving from five-year TIPS to 10-year TIPS. Another five years gives you about another 10 basis points per year. However, going beyond that only earns you about three basis points a year. And with real yields still below their historic averages for TIPS, you may not want to extend maturities much further than 15 years or so.

Here's a rough break-even analysis between the five-year and 15-year TIPS. The five-year TIPS is yielding about 0.3 percent, and the 15-year TIPS is yielding about 1.8 percent. If you bought the five-year TIPS, in five years the 10-year TIPS would have to yield over 2.5 percent for you to break even versus buying the 15-year TIPS yielding 1.8 percent. This analysis shows the cost of remaining short. Investors often forget to do the analysis and just assume that they should stay short when they expect rates to rise. The market also expects rates to rise and builds that expectation into current yields. Note that a real yield of 2.5 percent is slightly above the historical real return of nominal longer-term bonds.

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 or so, 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.

More on MoneyWatch:
How Bond Managers Hide Their Funds' True Risk Is Your Bond Fund's Rating a Lie? TIPS Update for January 2011 Is Inflation Risk Overstated? Laszlo Birinyi's Latest Prediction Is Interesting, but Worth Nothing
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