TIPS Update for January 2011

Last Updated May 13, 2011 11:03 AM EDT

After a sharp rise in real yields in November, the TIPS market stabilized since our last TIPS update, with rates pretty much unchanged.

Current and Historical Data The first table provides the historical data on the real return of nominal bonds from 1926 through November. 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 January 7.

Table 1: Historical Returns (%) 1926-November

Five Years

10 Years

20 Years

Nominal

Real

Nominal

Real

Nominal

Real

5.37

2.31

5.43

2.36

5.54

2.48

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


Five Years

10 Years

20 Years

Mean Yield

2.12

2.59

2.12**

Current Yield

0.05

0.98

1.63

Current as % of Mean

2%

38%

77%

Current as % of Historical Real Return

2%

42%

66%

** 20-year mean yields begin in July 2004.

The 10-year and 20-year nominal Treasuries are currently yielding about 3.3 percent and 4.3 percent, respectively. The break-even inflation rates are about 2.3 percent for the 10-year and 2.6 percent for the 20-year, both having increased 0.1 percent over the last month.

Given that the inflation estimate from the Philadelphia Federal Reserve is 2.2 percent over the next 10 years, there's still virtually no risk premium for unexpected inflation on 10-year nominals. On the 20-year TIPS, the risk premium is now 0.4 percent. Thus, while TIPS yields are at historically 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 2.0 percent, and the Philly Fed's five-year inflation forecast is 2.0 percent. Thus, the nominal five-year Treasury has an expected real return of 0 percent, slightly less than the TIPS yield. Here 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. Thus, there's a steep price to pay for keeping maturities short. For example, you pick up an additional 93 basis points in yield (or about 19 basis points a year) by moving from five-year TIPS to 10-year TIPS. 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.

Here's a rough break-even analysis between the five-year and 15-year TIPS. The five-year TIPS is yielding 0.05 percent, and the 15-year TIPS is yielding about 1.5 percent. If you bought the five-year TIPS, in five years the 10-year TIPS would have to yield 2.25 percent for you to break even versus buying the 15-year TIPS yielding 1.5 percent. That's because you earn just 0.05 percent in the first five years. That 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 2.25 percent is close to the historical real yield average 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, 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:
TIPS Update for December Setting the Record Straight on Municipal Bonds 16 Financial Resolutions for the New Year Long/Short Funds Come Up Short ETF Tradability Can Hurt Your Returns
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.
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    Larry Swedroe is director of research for The BAM Alliance. He has authored or co-authored 13 books, including his most recent, Think, Act, and Invest Like Warren Buffett. His opinions and comments expressed on this site are his own and may not accurately reflect those of the firm.

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