TIPS Update for March 2011

As of this writing, March 10, yields on TIPS have retreated from their February levels.

Current and Historical Data The first table provides the historical data on the real return of nominal bonds from 1926 through January. The second table shows both the mean TIPS yield and the percentage of time since 1997 that the TIPS yield has been above the mean. The current yields are as of the close of March 10.

Table 1: Historical Returns (%) 1926-January

The 10-year and 20-year nominal Treasuries are currently yielding about 3.35 percent and 4.24 percent, respectively. Break-even inflation rates have risen quite a bit in just the last few weeks. This is due to some combination of an increase in expected inflation and increase in the risk of unexpected inflation. The 10-year break-even rate is now about 2.5 percent, and the 20-year break-even rate is at around 2.6 percent.

Given that the inflation estimate from the Philadelphia Federal Reserve is 2.3 percent over the next 10 years, there's just a 0.2 percent risk premium for unexpected inflation on 10-year nominals. With the risk premium for unexpected inflation at just 0.2 percent, 10-year and 20-year TIPS seem to be the preferred choice over nominal Treasuries in relative terms.

Assuming that the 20-year inflation forecast is the same as the 10-year forecast, the risk premium is a bit higher at 0.3 percent. That still seems like a relatively small risk premium. Thus, TIPS remain the preferred choice.

Now let's look at the five-year maturity. The current yield on the five-year nominal Treasury is about 2.1 percent. With the Philadelphia Fed's five-year inflation forecast at 2.1 percent, the expected real return is zero, meaning it's still about 0.34 percent higher than the comparable TIPS yield. Again, given the relatively small risk premium, TIPS are still the preferred choice. It's important to note, however, that the "cost" of inflation insurance has increased over the past month.

TIPS yields are still well below the long-term average real yield of TIPS. 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 120 basis points in yield (or about 24 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 10 basis points per year. Going beyond that earns you about five 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 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.

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