TIPS Update for October 2011

On a monthly basis, I update the tables below to help you make decisions on purchasing Treasury inflation-protected securities. The data is as of October 13. 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.

* 20-year mean yields begin in July 2004.

Ten-year and 20-year nominal Treasuries are currently yielding about 2.18 percent and 2.88 percent, respectively. The 10-year yield is up about three basis points compared to last month, while the 20-year is down 20 basis points. Break-even inflation rates have fallen since last month. The 10-year and 20-year break-even rates are now about 1.9 and 2.0 percent, respectively.

Given that the third quarter inflation estimate from the Philadelphia Federal Reserve is 2.4 percent over the next 10 years, we see the risk premium for unexpected inflation on 10-year nominals has dropped from -0.3 percent to -0.5 percent over the last month. With the risk premium for unexpected inflation even more negative now at -0.5 percent on the 10-year, and -0.4 percent on the 20-year, TIPS are the clear choice over nominal Treasuries in relative terms. Simply put, TIPS investors are being paid even more for avoiding the risk of unexpected inflation.

Now let's review the five-year maturity. The current yield on the five-year nominal Treasury is about 1.1 percent. With the Philadelphia Fed's five-year inflation forecast at 2.3 percent, the expected real return is now -1.2 percent, meaning five-year TIPS have more attractive yields relative to nominals with their yield at -0.5 percent. Given the risk premium of -0.7 percent, TIPS are still the preferred choice.

The flight to quality pushing TIPS yields far below historical averages may mean certain investors should consider alternatives. For those investors who have greater capacity to accept the risk of unexpected inflation over the next five years, one alternative to consider is five-year CDs. Five-year CDs yielding 2.0 percent have a break-even inflation rate of 2.5 percent, or roughly 90 basis points over comparable nominal treasuries. When comparing TIPS to CDs, the market is offering a relatively low 0.2 percent risk premium for unexpected inflation. As with all things in life, there are tradeoffs -- which should be carefully considered in this instance. Investors comfortable losing the term premium by considering five-year CDs can reduce their term-risk exposure at a time when yields are at historically low levels.

TIPS prices have been flat in the intermediate term and rallied some in the longer end, keeping yields further below their long-term average real yields. However, as has been the case for quite a while, the steepness of the TIPS yield curve means intermediate-maturity TIPS are yielding much higher percentages of both the historical real return on nominal treasury bonds of the same maturity and the historical yield on TIPS. Thus, there's a steep price to pay for keeping TIPS maturities short.

For example, you pick up an additional 79 basis points in yield (or about 16 basis points a year) by moving from five-year TIPS to 10-year TIPS. Extending another five years gives you another eight basis points per year. Going beyond that earns you about six basis points a year. Given this, some investors could look at the steepness of the current TIPS curve and reason that it offers a decent yield pickup to target maturities in the 10 to 15 year range, if they're willing to accept the term risk. However, with real yields still below their historic averages for TIPS, those investors disinclined to subject their portfolios to additional price risk might find it more prudent to keep maturities to about 10 years or so.

While TIPS yields don't look attractive relative to historical averages, you can't buy yesterday's yields. And since our crystal balls are always cloudy, we can't know if the current yield on longer term TIPS will look like a good or bad yield in the future.

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 -- which for some investors could be too much volatility to stomach -- there's no risk of loss if you hold to maturity.

Summarizing, it seems prudent to limit maturities to about 10 years or so, since absolute yields are well 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 August/September 2011 Hedge Fund Update for Third Quarter 2011 John Bogle's Dream Fund Has the Small-Cap Premium Disappeared? How to View the Current Economic Situation
Three ways I can help you become a wiser investor:

• Follow me on Twitter: http://twitter.com/larryswedroe.
• Preorder my next book Investment Mistakes Even Smart Investors Make and How to Avoid Them.
• Download the podcast of my radio show via Buckingham Asset Management's iTunes page.