What to Consider When Buying TIPS

Last Updated Jan 19, 2010 10:42 AM EST

As I have written before, Treasury inflation-protected securities (TIPS) are an excellent fixed income vehicle for inflation-wary investors. However, it can be tough to know which TIPS are most appropriate. Here are some tips on TIPS.

Aversion to Inflation
Obviously, the more averse you are to inflation, the higher your allocation to TIPS should be. For example, if you're retired, inflation may be a bigger concern than it would be for someone still in the workforce.

Real Yields
Another consideration is if TIPS yields are high or low relative to the real return on nominal bonds of the same maturity. The higher TIPS yields are relative to the historical real return on nominal bonds, the greater the allocation to TIPS and the longer the maturity can be.

The following is a table showing the historical real returns of nominal return bonds from 1926 through November 2009. Keep in mind that this doesn't tell us what the real return on outstanding nominal bonds will be. That requires a clear crystal ball.
Five Years 2.17%
10 Years 2.26%
20 Years 2.43%
The Inflation Factor of an Individual TIPS
This is the amount of past inflation already built into a secondary TIPS purchase. All else equal, consider the bond with the lower inflation factor.

The Steepness of the Current TIPS Yield Curve
Generally speaking, the steeper the curve, the more you should consider extending the maturity of the TIPS you buy. However, it's not as simple when yields are low but the curve is steep. Low yields indicate keeping maturities short, while the steep curve suggests extending them. This may boil down to whatever you feel more comfortable owning.

Historical Yields
The following shows current and mean yields of TIPS since 1997 (when TIPS were first introduced).

Table 2: Current Yields and Mean Yield (%) 1997-November 2009

Five Years

10 Years

20 Years

Mean Yield

2.28

2.70

2.19**

Current Yield

.24

1.37

1.99

Current as % of Mean

3 11

51

91

Current as % of Historical Real Return

11

61

82

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

Five- and 10-year TIPS yields are below their historical mean. They're also 11 percent and 61 percent 3 percent and 11 percent of historical real returns, respectively. In contrast, the 20-year TIPS appears more favorable as its current yield is 91 percent of its mean and 82 percent of the 20-year real return.

Given the current positive slope of the TIPS curve, you can pick up additional yield for increasing maturity without taking inflation risk.

Those currently looking for the "sweet spot" for TIPS might consider the TIPS of 2025. Here's why: The current yield on the TIPS of 2020 is about 1.4 percent and the current yield on the TIPS of 2025 is about 1.9 percent. Thus, there's an extra 10 basis points a year currently available by extending the maturity from 10 to 15 years.

However, extending beyond 2025 results in an incremental yield of just a few basis points for each additional year. That might not be high-enough compensation for the extension risk, given that yields are below historical averages.
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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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