Friday, September 25, 2009

Advantages and Disadvantages of Treasury Inflation Protected Securities:

Update 12/1/16: I have recently published two posts at SeekingAlpha on this subject:

The Mechanics Of Purchasing A TIP In The Secondary Market - South Gent | Seeking Alpha

Update On Buying TIPs In The Secondary Market - South Gent | Seeking Alpha

Update 7/2/2009: I decided to start buying the 10 year treasury inflation protected bond directly at auction in my Roth IRA. The 10 year will be auctioned on Monday, July 6, 2009.

Treasury Auction of the Ten Year TIP on Monday
Update 7/7/09: This post contains the real yield and breakeven calculation for my recent purchase of the 10 year TIP: item #4:10 Year TIP Auction


I sold all of my TIP ETF shares in November, for the reasons described in Bill Tedford's Inflation Prediction & His Sell of TIPs & /Sold All Shares TIP ETF/Started Hedge for Corporate Bonds

5/29/12 Update: I sold all my 10 TIP bonds at 120.45:  Sold 3 TIP Bonds Maturing in 2019 at 120.45  (5/25/12).  The purchaser of those bonds will have a negative current yield of -.89%.

As of 5/28/12, the current yield on five and ten year TIPs are below zero. (current information available from the U.S. Treasury website:  Daily Treasury Real Yield Curve Rates)

Chart: 10-Year Treasury Inflation-Indexed Security- St. Louis Fed

Chart: 7-Year Treasury Inflation-Indexed Security- St. Louis Fed

Chart: 5-Year Treasury Inflation-Indexed Security- St. Louis Fed

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One purpose of writing this blog is to force myself to identify the advantages and disadvantages of owning a particular class of securities. By forcing myself to go through this process, I may be able to assess better when I may need to buy or sell a particular security, and how much of my capital should be devoted to it at any given point in time in my individualized asset allocation plan. A good example of this process is my discussions in the Fall of 2008 about Trust Certificates, floating rate and fixed coupon preferred stocks. Those blogs actually helped me to focus more on those types of securities more than I would have ordinarily have done, and that focus proved advantageous to me. Based on those earlier posts, I have summarized certain conclusions that I have drawn to date about the advantages and disadvantages of equity preferred stocks:

Today, I want to turn my attention to Treasury Inflation Protected securities. I currently own an ETF, TIP, that contains these securities. iShares Barclays TIPS Bond Fund (TIP) That funds currently contains 28 securities, and the fund's weighted average maturity is currently 9.12 years. The expense ratio is just .20%. Vanguard also offers a mutual fund with these securities. VIPSX MSN Another ETF is sponsored by SSGA, IPE, and it has an expense ratio of .18%. SPDR Barclays Capital TIPS ETF

There is a page in the Market Data section of the daily WSJ that contains prices for the individual issues: (TIPS)

What is a Treasury Inflation Protected Security:

The above linked page contains a simple explanation of the TIP. The principal of the TIP is tied to the rise and fall of the Consumer Price Index. The principal amount of the bond increases with inflation, and decreases with deflation. When the Treasury Inflation Protected Security matures, the Treasury will pay the greater of the original par value or the inflation adjusted principal. Interest is paid semi-annually.

I would add the following to that summary statement.

The semi-annual coupon is paid on the inflation adjusted principal. So, while the coupon is constant, it is applied to a constantly changing amount of principal adjusted by the rate of inflation.

TIPs are indexed to the Consumer Price All Urban Non-Seasonally Adjusted Index (CPI) with a 3 month lag.

When the TIP is originally sold by the Treasury, it has a lower guaranteed yield than a comparable maturity treasury security.

The U.S. government requires an owner of the TIP in a taxable account to pay income taxes on the inflation adjusted accretion to the principal before that accretion is paid at maturity. Investing Thus, most U.S. investors would want to hold these securities in a retirement account.


One last concept that needs to be understood is the break-even inflation rate, or how much inflation must happen prior to maturity to render the TIP a better buy than the non-inflation protected security.

So, for purposes of illustrating the concept of break-even, and just to keep it simple because the actual calculation is more complex, assume that the nominal yield of the non-inflation protected security is currently 4% and the yield on the TIP with the same maturity is 2%, then inflation would have to rise more than 2% during the remaining years until maturity to make the TIP a better buy now than the non-inflation protected security. That would be an averaged annualized inflation rate.

There is a data page in Barron's that give me a rough idea of the current break-even point. I found it in this week's issue at p. M42. (Added 7/9: it is easier to calculate breakeven from the data on the bond page at Bloomberg by subtracting the the yield for the TIP from the comparable maturity non-inflation protected security to arrive at breakeven)

Under "Inflation Indexed Treasury Securities, I found an issue maturing in January 2019, with a yield to maturity on accrued principal listed at 1.838%. I then looked at the quotes for non-inflation protected treasuries on the same page. I found one maturing in 2/2019 that yields 3.86%. So, roughly speaking, I figure the break-even is a 2.02% rise in inflation. If I expected less than 2% inflation, I would buy now the non-inflation protected security. If I expected more, which I do, then I would choose the TIP. But for reasons that I have explained in several prior posts, and summarized below, I am not enthusiastic to buy either now.

Here is a link to an article that contains a chart on the break-even spread: SeekingAlpha


1. The Market May be Pricing Nominal Yield Incorrectly: Part of the nominal yield of the non-inflation protected bond should include at least three components, though I would combine the last two: (a) A real yield before inflation plus (b) an inflation expectation and (c) a risk premium for the uncertainty of the inflation expectation. The ten year treasury was yielding 2.08% on 12/18/, 

Was the market in your estimation pricing correctly the potential for inflation and a risk premium for that prediction into that yield? Or, was the yield based on irrational fears causing a mindless flight to what many investors considered to be a "safe" investment. This is relevant since the TIP break-even point is priced off that nominal yield. So if a more rational price was a 4% nominal yield rather than 2%, then both the TIP and the comparable non-inflation protected treasury would be priced too high, with a too low of a yield, based on factors other than a rational pricing of inflation expectations over ten years and a premium for the uncertainty of those predictions. However, the price in the TIP may not go down as much in value when the nominal yield corrects to 4% in the above hypothetical, due to changes in the break-even point.

Currently the real yield on the 10 TIP is less than 2%. In an inflationary environment, investors may demand more of a real yield for the TIP, and the breakeven point may also increase, in order for the investors to be comfortable that they would actually be receiving a real yield. If there was 6% inflation two years from now, I would expect an older TIP, with a 1.8% real yield and a 1.9% breakeven, to fall in price to make it equivalent to a new TIP offering in real yield and breakeven spread. The accretion to the principal due to the increased inflation may not make up for the fall in price.

It would not be difficult to find an expert who says that inflation will soar and another who will claim that a 1% 30 year treasury is a good investment. Eventually, every investor has to make their own decision. Speaking for myself, I do not believe that the non-inflation protected 10 year treasury is correcting pricing the inflation risk and the uncertainty premium for that risk. This makes it an undesirable investment for me, and I would have no interest in any non-inflation protected security paying less than 4% with a ten year maturity, unless I was close to 100% certain of another Great Depression on the horizon, as opposed to a massive worldwide effort to inflate with huge and unprecedented fiscal and monetary stimulus programs.

2. Break-Even May be Priced Too High: For many months not long ago, the break-even was being priced at around 2.5%. If that proves to be too high, the investor would have been better off just buying the non-inflation protected security. With significant periods of deflation and a relatively short duration, the odds of being worse off with the TIP would increase.

3. Problem with Mutual Funds and ETFs: A mutual fund and an ETF do not promise to return your original investment to you. If the value of the holdings decline then the fund will decline in value. On the other hand, if you buy an individual security, the value may fluctuate during the period prior to maturity, but the investor will receive the greater of the original par value or the inflation adjusted principal when buying an individual TIP issue rather than an ETF or a mutual fund. FINRA - Investor Information - Smart Bond Investing Eventually, probably within the next five years, I will transition to owning just individual TIP securities for this reason. Some firms do not charge for placing a non-competitive bid at a TIP's auction.

4. Possible Temporary Distortions By Quantitative Easing: Until the FED stops buying massive amounts of both the TIP, the non-inflation protected treasuries and the mortgage backed securities, who really knows whether the current pricing is even the market price?

5. Tax Issues: If held in a taxable account Uncle Sam expects taxes to be paid on the inflation adjusted accretions to principal.

6. Using CPI: Some critics argue that CPI does not correctly measure the true rate of inflation.


1. Some inflation protection is provided by the TIP: While the market may be pricing the nominal yield wrong at a given point in time, at least the TIP has some protection against a mispricing of inflation risks compared to a fixed coupon bond. Swenson recommends buying TIPs to hedge against the inflation risk. Bloomberg

2. At times, the market may charge nothing or a nominal amount for inflation protection: In the fall of 2008, the market was charging almost nothing for the inflation protection of the TIP, with a break-even hovering near zero. TREASURY INFLATION PROTECTED BONDS (TIP) This was when I made my last purchase. For an investor looking to buy either the TIP or the non-inflation protected security, and believes that zero inflation over a 10 year period is just an asinine prediction, then the TIP would be a better buy under those circumstances and assumptions.

3. TIP as a Non-Correlated Asset: Many financial advisors recommend the TIP as a non-correlated asset in an asset allocation scheme. Treasury Inflation Protected Securities as a Non-Correlated Asset During the stock market swoon in 2008, the TIP would have had a negative correlation or a very low positive correlation, which means it was going up, or down just a tad, when stocks were tanking, an important consideration. The TIP ETF had a total return based on market value in 2008 of -.53 and is up this year so far: TIP MSN

4. Ravages of High or Hyper Inflation: The current break-even point is around 2% on the ten year maturity. What if inflation comes back soon, similar or worse than the late 1970s and early 1980s. Consumer Price Index, 1913- | The Federal Reserve Bank of Minneapolis The rate of inflation in the late 1960s to the early 1980s will wreck a fixed coupon, non-inflation protected bond portfolio. Over the past ten years, inflation has averaged close to 2.5% but the data linked above shows that CPI can rise over extended periods at a higher rate than recent experience.

I may add to or change this post after considering this issue further, and will just note any amendments or changes.

This is a link to a discussion of the TIP at the Finra site: FINRA - Investor Information - Smart Bond Investing

An article written after the date of this post has some helpful charts and discussion in it.

Floaters as an Alternative to the TIP during the Fall 2008 and 1st Quarter 2009: Increased credit risk but more yield opportunity then/Role of Dynamic Asset Allocation:

Rather than buying the TIP, I have focused for several months now on buying floating rate securities that pay the greater of a guarantee or some percentage above a short term rate such as the 3 month treasury bill or 3 month LIBOR. For a period of time during the Fall of 2008 and early 2009, many of these securities were being priced at substantial discounts to par value which juiced both the guaranteed yield, what I call the deflation or low inflation protection, and the potential yield of the floating rate, what I call the inflation protection component. My buys in this area, along with discussions of their advantages and disadvantages, are contained in the links provided in this Gateway Post: Floaters: Links in One Post

Of course, I assume more credit risks with these corporate issues, particularly the ones classified as equity preferred and those with non-cumulative dividends, but the pricing at substantial discounts to par value more than compensated me for those risks in my view. The pricing discount to par value has recently narrowed significantly in recent weeks, making them far less attractive to me, and I have virtually no interest in them now. I am more interested in waiting for an opportunity to add to my TIP position.

Dynamic Asset allocation & an Inefficient Market:

So, under my dynamic asset allocation approach, I tried to take advantage of the opportunities presented by the market pricing of the floaters, documented in scores of trades in my blog, and to a lesser extent the nominal break-even pricing of the TIP in the 4th quarter of 2008, believing that every investor has to be flexible and to take advantage of whatever opportunities are provided by the market, which is not viewed here at HQ as an efficient market:

See discussion in Joe Nocera's column in the Saturday NYT about efficient market theory, regarded as a bunch of hooey here at HQ: NYT


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