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Swedroe: TIPS update for June

(MoneyWatch) 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 June 21. The first table provides the historical data on the real return of "nominal" Treasury bonds from January 1926 through April 2012. The second table shows the current and mean TIPS yields. (My thanks to my BAM colleagues Dan Rush and Bruce McGee for pulling the data.)

Since last month's update, yields on five-year TIPS have risen by two basis points, while 10- and 20-year TIPS yields have fallen by six and four basis points respectively. The five-year TIPS yield is now -1.05 percent, the 10-year TIPS yield is now -0.50 percent, and the 20-year has fallen to 0.13 percent. Nominal Treasury yields have had an even greater decrease. The five-year Treasury bond has fallen to 0.72 percent (a decrease of 0.03 percent), the 10-year has fallen to 1.61 percent (a decrease of 0.15 percent), and the 20-year yield has fallen to 2.25 percent (down 0.15 percent).

The second-quarter inflation estimate released last month from the Philadelphia Federal Reserve was 2.48 percent over the next 10 years, up from the previous quarter's estimate of 2.3 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 decreased from -0.02 percent to -0.36 percent over the past month. With the risk premium for unexpected inflation negative, TIPS should be preferred over nominal Treasuries of the same maturity.

The Philadelphia Fed's second-quarter five-year inflation forecast is 2.35 percent. Five-year nominal Treasuries now yield 0.72 percent, which makes the expected real return -1.63 percent, a decrease of 0.03 percent from last month. The market break-even rate between Treasuries and TIPS for five years is 1.78 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 0.55 percent yield pick-up (or about 0.11 percent per year). This is down from 0.13 percent per year last month. Extending another five years gives you around 0.09 percent per year, and beyond that around 0.06 percent per year. Currently, to get positive real yields, investors would have to extend to the 2028 maturity (0.02 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.

An interesting TIPS bond currently is the maturity that comes due on April 15. This bond has a coupon of 0.625 percent and is currently the only tips maturity under 15.5 years that offers a positive current yield. At the time this was written, this issue was being offered at a price of $100.25 and a current yield of 0.313 percent. A par of $250,000 would have a current inflation dollar amount of $22,005.00 and is projected to grow (using current CPI-U as calculated by Bloomberg) to a dollar amount of $25,067.50.

In addition to the projected growth, it'll pay interest at the coupon rate on October 15 and at maturity. These projections are based on what has occurred to date, but with a short maturity of April 2013, it may be worthwhile to consider for a short-term investment, especially compared with other rates available for similar maturities. Of course, you must consider the risk of cumulative deflation over the period, which would result in the TIPS maturing at less than the price paid.

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.

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