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TIPS Update for May 2011

Before we get into our monthly TIPS update, I had one more comment about Brett Arends' article on TIPS being a poor investment right now due to negative real yields.

In the article, Arends quotes Tom Atteberry, manager of the FPA New Income bond fund (FPNIX), as saying "I struggle with why someone would accept a negative real return on their money."

Yesterday, we discussed the reasons why buying investments with a negative return can still be a good idea. Still, I was curious about Atteberry's track record. According to Morningstar, FPNIX carries a two-star rating and has underperformed its benchmark by 1.22 percent per year for the past 10 years. Which raises the question of why anyone would care what Atteberry thinks about TIPS.

And now, on with the update.

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 May 9. The first table provides the historical data on the real return of nominal bonds from 1926 through February. 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.

* 20-year mean yields begin in July 2004.

The 10-year and 20-year nominal Treasuries are currently yielding about 3.17 percent and 4.03 percent, respectively. These yields are down about one-quarter of a percent from the month earlier period when they were 3.46 percent and 4.27 percent, respectively. Break-even inflation rates are about the same as they were a month ago. The 10-year and 20-year break-even rates are now both about 2.5 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, the same as last month. With the risk premium for unexpected inflation at just 0.2 percent on both the 10-year and 20-year, TIPS seem to be the preferred choice over nominal Treasuries in relative terms.

Now let's look at the five-year maturity. The current yield on the five-year nominal Treasury is about 2.0 percent. With the Philadelphia Fed's five-year inflation forecast at 2.1 percent, the expected real return is now -0.1, meaning it's about 0.4 percent higher than the comparable TIPS yield -- an increase of 0.1 percent from the prior month. Again, given the relatively small risk premium, TIPS are still the preferred choice, though the case is less clear now. Those who have greater capacity to accept the risk of unexpected inflation might prefer to own nominal bonds, especially with just a five-year maturity.

With the recent rally in TIPS prices, yields are 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 114 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 six 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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