TIPS Update: 15 Years Still the Sweet Spot
Our last post on TIPS was April 5, so I thought it worthwhile to provide an update.
Current and Historical Data
The first table provides the historical data on the real return of nominal bonds from 1926 through March 2010. (Please note that the April CPI hasn't been released yet. That's why the numbers are through March.) The second table shows both the mean TIPS yield and the percentage of the historical mean real return on nominal bonds.
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Table 1: Historical Returns (%) 1926- March 2010 |
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Five Years |
10 Years |
20 Years |
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|
Nominal |
Real |
Nominal |
Real |
Nominal |
Real |
|
5.33 |
2.25 |
5.36 |
2.28 |
5.43 |
2.35 |
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Table 2: Current Yields and Mean Yield (%) 1997- Present |
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Five Years |
10 Years |
20 Years |
|
| Mean Yield |
2.21 |
2.66 |
2.18** |
| Current Yield (as of 5/15) |
0.28 |
1.20 |
1.71 |
| Current as % of Mean |
13% |
45% |
78% |
| Current as % of Historical Real Return |
12% |
53% |
73% |
Our starting point for analyzing TIPS is the inflation estimate from the Philadelphia Federal Reserve -- 2.4 percent over the next 10 years. With current 10- and 20-year nominal Treasuries yielding about 3.4 percent and 4.1 percent, respectively, the break-even inflation rates are about 2.2 percent for the 10-year and 2.4 percent for the 20-year. Since the break-even rates are either at or below the Philly Fed's forecast, TIPS should be the clear choice over nominal Treasuries, since there's no risk premium for unexpected inflation. With the five-year nominal Treasury yielding about 2.1 percent, and the Philly Fed's five-year inflation forecast at 2.2 percent (meaning negative expected return for the nominal five-year Treasury), the five-year TIPS should also be the preferred choice relative to the nominal bond. When was the last time you got to buy insurance and not pay a premium?
We also need to consider that current TIPS yields are below the long-term average real yield of both nominal bonds and TIPS. But because the TIPS yield curve is steep, longer-maturity TIPS are yielding much higher percentages of both the historic real return on nominal bonds of the same maturity and the historical yield on TIPS. Note that by moving from five to 10 years, you pick up an additional 92 basis points in yield, or about 18 basis points a year. With the 15-year TIPS yielding 1.57 percent, you earn another 37 basis points (or about 7 basis points per year) by extending another five years. However, going beyond that only earns you about three or four basis points a year. And with real yields well below their historic averages for TIPS, you may not want to extend maturities much further than 15 years.
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, there's no risk of loss if you hold to maturity.
Summarizing, it seems prudent to limit maturities to about 15 years (the current sweet spot), since absolute yields are still 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.