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TIPS Update for July 2011

On a monthly basis, I update the tables below to help you with decisions on TIPS. The data is as of July 12. The first table provides the historical data on the real return of nominal bonds from 1926 through April. The second table shows the mean TIPS yield and current yields.

The 10-year and 20-year nominal Treasuries are currently yielding about 2.89 percent and 3.84 percent, respectively. These yields are down about nine and four basis points from the month earlier period when they were 2.98 percent and 3.88 percent, respectively. Break-even inflation rates have risen since last month. The 10-year and 20-year break-even rates are now about 2.4 and 2.5 percent, respectively.

Given that the inflation estimate from the Philadelphia Federal Reserve is 2.4 percent over the next 10 years, we see the risk premium for unexpected inflation on 10-year nominals held constant at zero. With no risk premium for unexpected inflation on the 10-year, and a negative risk premium of -0.1 percent on the 20-year, TIPS are clearly the preferred choice over nominal Treasuries in relative terms.

Now let's review the five-year maturity. The current yield on the five-year nominal Treasury is about 1.5 percent. With the Philadelphia Fed's five-year inflation forecast at 2.35 percent, the expected real return is now -0.9 percent, which is worse than the current -0.7 percent yield on five-year TIPS. Given the negative risk premium for unexpected inflation, TIPS are again the preferred choice.

With recent economic data being weaker than expected, TIPS prices continued their rally, pushing yields further below their long-term average real yields. However, as has been the case for quite a while, the steepness of the TIPS yield curve means 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. Thus, there's a steep price to pay for keeping maturities short.

For example, you pick up an additional 117 basis points in yield (or about 23 basis points a year) by moving from five-year TIPS to 10-year TIPS. Extending another five years to 15 years gives you about another 11 basis points per year. Going beyond that earns you about eight basis points a year. And with real yields still below their historic averages for TIPS, you may not want to extend maturities much further than about 15 years or so.

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, there's no risk of loss if you hold to maturity.

Summarizing, it still seems prudent to limit maturities to about 15 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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