For TIPS, limit maturities to 10 years
(MoneyWatch) I have updated the tables below on Treasury inflation-protected securities. The data is as of Nov. 15. The first table provides the historical data on the real return of "nominal" Treasury bonds from January 1926 through October 2012. The second table shows the current and mean TIPS yields.
In the past month, yields on five-year TIPS have risen by 0.09 percent, while 10-year and 20-year TIPS yields have fallen by 0.03 percent and 0.09 percent, respectively. The five-year TIPS yield is now -1.51 percent, the 10-year TIPS yield is now -0.83 percent, and the 20-year TIPS yield has fallen to -0.11 percent. With the exception of the TIPS maturing April 15, 2013 (which is yielding 0.37 percent), TIPS bonds out through 20 years are all at negative yields. Only the last three maturities -- February 2040, February 2041 and February 2042 -- offer positive real yields. Nominal treasuries have continued to also hold at low levels, with the five-year Treasury yielding 0.61 percent, the 10-year treasury yielding 1.58 percent, and the 20-year treasury yielding 2.23 percent.
The latest release from the Philadelphia Federal Reserve for the fourth-quarter inflation estimate was 2.30 percent over the next 10 years, down from the previous quarter's estimate of 2.35 percent. The risk premium for unexpected inflation (the difference between the headline CPI estimate from the Philadelphia Fed forecasters and the break-even rate between nominal Treasuries and TIPS) on 10-year nominal bonds was virtually unchanged, increasing from -0.11 percent to 0.12 percent over the past month. This means that the risk premium for unexpected inflation is slightly positive for the first time in a while. On the surface, this would slightly favor nominal Treasuries over TIPS. However, investors who are averse to the risks of unexpected inflation should still prefer TIPS over nominal Treasuries of the same maturity.
The Philadelphia Fed's fourth-quarter five-year inflation forecast is 2.28 percent. Five-year nominal Treasuries now yield 0.61 percent, which makes the expected real return -1.67 percent, a decrease of 0.04 percent from last month. The market break-even rate between Treasuries and TIPS for five years is 2.12 percent, which indicates that five-year TIPS are more attractive than nominal five-year Treasuries.
The TIPS curve continued to flatten over the past month. With real yields near their historic lows and the curve flattening due to demand for longer maturities, it makes it even more difficult to extend maturities. Currently, by extending from the five-year TIPS to 10-year TIPS, there's a 0.67 percent yield pick-up (or about 0.13 percent per year). Extending another five years gives you around 0.11 percent per year, and beyond that around 0.07 percent per year. Currently, to get positive real yields, investors would have to extend to the 2040 maturity (0.21 percent).
While TIPS yields don't look attractive relative to historical averages, you can't buy yesterday's yields, only today's. And since our crystal balls are always cloudy, we can't know if the current yield on longer-term TIPS will look good or bad 10 years or more in the future.
As always, one 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.
The decision of when to purchase TIPS -- and when not to -- can be a confusing one. The most important factor is the need for inflation protection. If you're living off of your portfolio and/or have a fixed pension, that could indicate a situation where TIPS might be a significant part of the solution. For other cases, it's certainly not as clear, complicated by the fact the answer changes over time.
For example, CDs have currently yields that range from 0.5 percent to 0.8 percent higher than conventional Treasuries. From a held-to-maturity point of view, this means TIPS will underperform CDs of comparable maturities unless inflation ends up being significantly higher than it's expected to be. This is certainly not impossible, but it does cause additional thought for someone who may not need inflation protection. Worth noting is that the current state of affairs and spreads between various investment products does change and in instances where other investments are closer to Treasury yields, TIPS will be a more attractive solution relative to the other investment vehicle.
Summarizing, it still 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 stock allocation, thereby reducing the risk of the overall portfolio without lowering expected returns.