TIPS Update for November

Last Updated Nov 10, 2010 9:24 AM EST

I thought it especially important to do one now, given the continued sharp rally in TIPS prices that has resulted in the currently very low yields.


Current and Historical Data The first table provides the historical data on the real return of nominal bonds from 1926 through August. 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 Nov. 9.

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

Five Years

10 Years

20 Years

Nominal

Real

Nominal

Real

Nominal

Real

5.38

2.32

5.46

2.39

5.61

2.54

* Interpolated data

Table 2: Current Yields (as of Nov. 9) and Mean Yield (%) 1997 -- Present


Five Years

10 Years

20 Years

Mean Yield

2.15

2.61

2.14**

Current Yield

-0.45

0.54

1.23

Current as % of Mean

n/a

21%

57%

Current as % of Historical Real Return

n/a

23%

48%

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

The 10- and 20-year nominal Treasuries are currently yielding about 2.7 percent and 3.8 percent, respectively, (increases of about 0.3 percent and 0.4 percent since our last report). The break-even inflation rates are about 2.2 percent for the 10-year (up from 2.0 percent in our last update) and 2.6 percent (up from 2.2 percent in our last update) for the 20-year.

Given that the inflation estimate from the Philadelphia Federal Reserve is 2.3 percent over the next 10 years, there is currently a small negative risk premium (0.1 percent) for unexpected inflation on the 10-year TIPS, with you getting the risk premium. On the 20-year TIPS, the risk premium is just 0.2 percent. Thus, while TIPS yields are at historically low levels, TIPS continue to look like a clear choice over nominal Treasuries in relative terms.

The same is true of the five-year TIPS. The five-year nominal Treasury is yielding about 1.3 percent (up from 1.2 percent at the time of our last update), and the Philly Fed's five-year inflation forecast is 2.0 percent. Thus, the nominal five-year Treasury has an expected return of -0.7 percent versus the TIPS yield of -0.5 percent. Once again, we see that you're getting insurance with a negative premium.

There is 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 99 basis points in yield (or about 20 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 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.

More on MoneyWatch:


With TIPS, Should You Buy, Hold or Sell? Why the Concern over Negative TIPS Yields Is Overblown What Is the Investment Impact of Our Federal Deficit? Vanguard Bond Funds Are Not All Created Equal Why GNMAs Shouldn't Be Your Bond Choice

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    Larry Swedroe is a principal and director of research for the BAM Alliance. He has authored or co-authored 12 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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