Are TIPS Cheap?
I’ve been getting lots of questions about whether Treasury inflation-protected securities (TIPS) are a good investment, with the yield at just 0.32% on the five-year. To answer the question of whether TIPS are cheap or expensive relative to Treasuries, I’ll discuss how to make the determination of whether to purchase TIPS or nominal fixed-income securities. To begin, we need to recognize there are two ways one can hold TIPS and nominal bonds: purchase the bonds individually or invest in mutual funds/exchange traded funds (ETFs). When investing through taxable accounts and IRAs, one can do either. However, in corporate retirement plans, such as a 401(k), one is limited to funds.
To keep the analysis simple, I’ll analyze TIPS and nominal Treasury bonds with five-year maturities. (The same analysis can be done for other maturities.) As of this writing, July 10, 2019, the five-year TIPS was yielding 0.30%, and the five-year nominal Treasury was yielding 1.81%. Thus, the breakeven inflation rate was just 1.51%. It’s important to understand why that does not mean the market is estimating future inflation of 1.51%.
There are two reasons why you cannot make that assumption. The first is that nominal Treasury bonds are the most liquid market in the world. While TIPS are relatively liquid securities and also carry the full faith and credit of the U.S. government, they are not as liquid as nominal Treasury bonds. Thus, investors in nominal Treasury bonds pay a premium (in the form of a lower yield) to own them. The second is that the yield on nominal Treasury bonds has three, not two, components: the real yield, the expected rate of inflation and a risk premium for unexpected inflation. TIPS yields are determined only by the real yield.
The liquidity premium (which depresses yields) and the risk premium for unexpected inflation (which increases yields) work in opposite directions and may cancel each other out. If that is the case, the TIPS-to-nominal-bond spread is a good indicator of the market’s aggregate view of expected inflation.
To obtain an estimate of expected inflation, we might use the Federal Reserve Bank of Philadelphia’s Survey of Professional Forecasters. This survey is the oldest quarterly survey of macroeconomic forecasts in the United States. It began in 1968 and first was conducted by the American Statistical Association and the National Bureau of Economic Research. The Federal Reserve Bank of Philadelphia took over the survey in 1990. Those making forecasts include more than 50 economists from many of the leading financial and research institutions in the country. Their views help shape opinions about expectations for inflation. And they are a consensus forecast – the “wisdom of the crowd.” You can find the complete list of participants within the survey.
The survey’s second quarter 2019 estimate for inflation over the next 10 years is 2.20%, which is 0.79 percentage point higher than the breakeven inflation rate of 1.51%, obtained by comparing the yields on TIPS and nominal Treasury bonds. (The survey’s forecast for the period ending 2022 is 2.10%). Thus, ignoring the liquidity premium, instead of having to pay a premium to hedge the risk of unexpected inflation, investors are actually being paid a premium (0.79%). How often do you get paid to avoid risk?
An alternative method is to use the five-year inflation swap rate. According to Bloomberg data, the inflation swap’s current market price is 2.10%. Using 210% as the inflation estimate provides an expected return on five-year TIPS of 2.40%, or 0.59 percentage point more than the nominal Treasury yield of 1.86%. Again, the negative premium of 0.59 percentage point makes TIPS the obvious choice relative to Treasury bonds.
The academic research, including the 2004 study “Asset Allocation with Inflation- Protected Bonds,” the 2006 study “Diversification Benefits of Treasury Inflation Protected Securities: An Empirical Puzzle” and the 2016 study “Residual Inflation Risk,” makes the case that, because of their diversification benefits, unless the risk premium for unexpected inflation is large, investors should strongly prefer TIPS. This is especially true for investors vulnerable to inflation (such as retirees living on a fixed income).
How large a premium is required before investors might prefer nominal bonds? Philipp Illeditsch, author of “Residual Inflation Risk,” concluded that “Investors should hold a zero-investment portfolio of nominal bonds.”
That’s too extreme a statement, especially for investors who have more ability to bear the risk of unexpected inflation. For example, for investors still in the workforce, real wages tend to keep up with inflation.
S.P. Kothari and Jay Shanken, authors of “Asset Allocation with Inflation-Protected Bonds,” looked at this issue too, specifically in terms of five-year maturities. They concluded that the preference for inflation-protected securities is so strong that if there is no inflation risk premium, the optimal allocation to them is 80%. Even with an inflation risk premium of 50 basis points, the optimal allocation is still 60%.
Given that investors in TIPS are not currently sacrificing any expected return (in fact, they have a higher expected return), they should greatly prefer five-year TIPS to five-year Treasury bonds.
Now let’s look at the issue when the investor has the ability to buy individual bonds. Because neither bond investment incurs any credit risk, there is no need to diversify credit risk. Thus, the main benefit of a mutual fund is no longer relevant. As long as investors are willing to sacrifice the conveniences of a fund (such as the ability to automatically reinvest interest), they can buy individual certificates of deposit (CDs) instead of a Treasury bond or a Treasury bond fund. FDIC-insured CDs typically carry significantly higher yields than Treasury bonds of the same maturity – which is why my firm generally buys them instead of nominal Treasury bonds when building laddered portfolios.
As I write this, the yield on a five-year CD in the secondary market (where CDs trade just like bonds) is 2.40%. Adding the Philadelphia Federal Reserve’s survey estimated inflation rate of 2.20% to the current TIPS yield of 0.30%, provides an expected return of 2.50 percent, above the yield on the CD. Thus, you are actually being paid a premium to avoid the risk of unexpected inflation. Note that it is often possible to find higher yields in the primary market by shopping around at such sites as this, which would make CDs relatively more attractive.)
The bottom line is that TIPS look cheap relative to both Treasuries and CDs.
Larry Swedroe is the director of research for The BAM Alliance.
This article originally appeared on AdvisorPerspectives.com.
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