TIPS Update for October

Since it has been about a month, it's time for our update on TIPS. I thought it especially important to do one now, given the continued sharp rally in TIPS prices that has resulted in the currently very low yields.

Current and Historical Data The first table provides the historical data on the real return of nominal bonds from 1926 through August. 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 October 11, 2010.

Table 1: Historical Returns (%) 1926 -- August

* Interpolated data

Table 2: Current Yields (as of Oct. 11) and Mean Yield (%) 1997 -- Present

** 20-year mean yields begin in July 2004.

With current 10- and 20-year nominal Treasuries yielding about 2.4 percent and 3.4 percent, respectively, the break-even inflation rates are about 2.0 percent for the 10-year and 2.2 percent for the 20-year. Given that the inflation estimate from the Philadelphia Federal Reserve is 2.3 percent over the next 10 years, the break-even rates are slightly below forecasted inflation. Thus, while TIPS yields are at historically low levels, TIPS continue to look like a clear choice over nominal Treasuries in relative terms, because investors aren't paying a premium for unexpected inflation.

The same is true of the five-year TIPS. The five-year nominal Treasury is yielding about 1.1 percent, and the Philly Fed's five-year inflation forecast is 2.0 percent (meaning the nominal five-year Treasury has an expected return of -0.9 percent versus the TIPS yield of -0.35). Basically, you're getting insurance with a negative premium.

There is another point to consider. Current TIPS yields are below the long-term average real yield of both nominal bonds and TIPS, but the steepness of the TIPS yield curve means longer-maturity TIPS are yielding higher percentages of both the historic real return on nominal bonds of the same maturity and the historical yield on TIPS. You pick up an additional 74 basis points in yield (or about 15 basis points a year) by moving from five years to 10 years. Another five years gives you about another 11 basis points per year. However, going beyond that only earns you about five 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.

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, 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.