Inflation protection: Swedroe's monthly TIPS update

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 February 17. The first table provides the historical data on the real return of "nominal" Treasury bonds from 1926 through December. The second table shows the current and mean TIPS yields.

Since our last update, TIPS yields have held fairly steady. Ten-year TIPS yields are now -0.26 percent, and the 20-year is 0.42 percent. This is a decrease of 0.04 and 0.02 percent, respectively. Meanwhile, nominal Treasury yields have increased. The 10-year has risen to 2.01 percent (an increase of 0.16 percent), and the 20-year yields 2.77 percent (up 0.23 percent). The 10-year and 20-year break-even rates are now about 2.27 percent and 2.35 percent, respectively.

The first-quarter inflation estimate from the Philadelphia Federal Reserve released this month was 2.3 percent over the next 10 years, down from 2.5 percent from last quarter. 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 decreased from -0.42 percent to -0.03 percent over the past month. With the risk premium for unexpected inflation continuing to be negative, TIPS should be considered over nominal Treasuries of the same maturity.

The Philadelphia Fed's first-quarter five-year inflation forecast is 2.3 percent, down from 2.4 percent last quarter. Five-year nominal Treasuries now yield 0.88 percent, which makes the expected real return -1.42 percent, an increase of 0.20 percent from last month. The market break-even rate between Treasuries and TIPS is 2.06 percent, which means a -0.24 percent risk premium, according to the Philadelphia Fed estimate. This would mean that five-year TIPS have more attractive yields relative to the nominal five-year Treasury.

Although TIPS yields were lower across five-, 10- and 20-year maturities, the TIPS curve steepened slightly over the past month. The shorter maturities had the strongest performance, while the 10-year and 20-year maturities were fairly unchanged. The five-year maturity decreased 0.23 percent. Currently, by extending from the five-year TIPS to 10-year TIPS, there's a 0.92 percent yield pick-up (or about 0.18 percent per year). This is up from 0.15 percent per year last month. Extending another five years gives you around 0.10 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 2025 maturity (0.05 percent).

With real TIPS yields even further below their historic averages, those investors disinclined to subject their portfolios to additional price risk might find it more prudent to limit maturities to about 10 years. However, the current 10-year TIPS is only a 0.125 percent coupon. A low coupon bond will generally have greater price risk than one of a similar maturity with a bigger coupon. An alternative to buying the current 10-year TIPS would be to extend another three years to the 13-year TIPS. It has a 2.375 percent coupon and captures an additional 0.33 percent of real yield. The maturity extension will add to the price risk, but the bigger coupon will help to dampen this volatility.

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 like good or bad 10 years or more 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 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 equity allocation, thereby reducing the risk of the overall portfolio without lowering expected returns.

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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.