Swedroe: TIPS update for May

(MoneyWatch) Every month, I update the tables below to help you make decisions on purchasing Treasury inflation-protected securities. The latest data is as of May 24, 2012. The first table provides the historical data on the real return of "nominal" Treasury bonds from January 1926 through March 2012. The second table shows the current and mean TIPS yields.

Since last month's update, yields on five-year TIPS have risen, while 10- and 20-year TIPS yields have fallen. The five-year TIPS yield is now -1.07 percent, 10-year TIPS yield is now -0.44 percent, and the 20-year has fallen to 0.17 percent. Nominal Treasury yields have had an even greater decrease. The five-year has fallen to 0.75 percent (a decrease of 0.09 percent), the 10-year has fallen to 1.76 percent (a decrease of 0.22 percent), and the 20-year yield has fallen to 2.4 percent (down 0.32 percent). This changed the five-year, 10-year, and 20-year break-even rates to 1.82 percent, 2.2 percent, and 2.23 percent, respectively.

The second-quarter inflation estimate from the Philadelphia Federal Reserve released this month was 2.48 percent over the next 10 years, up from last 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 -0.28 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 0.75 percent, which makes the expected real return -1.60 percent, a decrease of 0.14 percent from last month. The market break-even rate between Treasuries and TIPS is 1.82 percent, which means a -0.53 percent risk premium, using the Philadelphia Fed estimate. This means that five-year TIPS are more attractive than nominal five-year Treasuries.

The TIPS curve flattened over the past month. Shorter maturities increased 0.13 percent, while the 10-year and 20-year maturity yields decreased 0.13 percent and 0.19 percent, respectively. 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 0.63 percent yield pick-up (or about 0.13 percent per year). This is down from 0.18 percent per year last month. Extending another five years gives you around 0.08 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 2027 maturity (0.01 percent).

As we have mentioned the last couple months, TIPS yields are still well below their historic averages. Therefore, 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 0.26 percent of real yield. The maturity extension will add to the price risk, but the bigger coupon will help to dampen this volatility, and you pick up the 26 basis points in incremental yield. This would only be appropriate for investors able to stomach the potential volatility. The 2025 maturity TIPS are trading at a -0.16 percent real yield. If its yield rose to 1.00 percent, the price would fall about 10.1 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 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 stock allocation, thereby reducing the risk of the overall portfolio without lowering expected returns.