Wednesday, October 8, 2008

TIPS are a steal

Can't resist posting this chart, to follow up on my earlier post below. The big rise in TIPS yields is hard to explain or understand. Here is a bond guaranteed by the US government to pay you a real yield of almost 3% per year if you hold it to maturity. Whatever your forecast of the economy or the market, the only thing that can go wrong with this investment is the collapse of our government. And if that happens, heaven help us because nothing is going be guaranteed at all. We saw higher real yields in 2000, but that was back when nobody was looking; TIPS were still largely unknown, and not very liquid. There is a limit to how high guaranteed real yields can go, I believe, and that's because the higher they get the more they beat every other investment on the planet in risk-adjusted terms. That also means that the downside risk to owning TIPS (due to rising interest rates) is getting increasingly very limited.

5 comments:

Jon S. said...

Scott: can you give a real-world example to someone like me who's a bit math-challenged: if I bought $10,000 in TIPS today, what would that be worth when it comes to maturity?

Scott Grannis said...

Let's say you buy $10K worth of 10-yr TIPS. They currently have a 2.7% real yield. The face value of the bonds will rise by a rate that is equal to the rise in the consumer price index. If the CPI averages 3% a year for 10 years, you will have bonds with a face value of $13,440 at maturity. Plus, each year you will receive a coupon payment equal to 2.7% of the inflation-adjusted face value of the bonds.

To summarize. If inflation is 3% a year, the return on your investment will be (1.03) * (1.027) - 1, or 5.78% per year. If inflation is 4% per year, your annual return will be (1.04) * (1.027) - 1, or 6.8% per year.

One caveat: if you hold TIPS in a taxable account the inflation accretion of the face value is treated as OID.

Jon S. said...

Thanks very much -- I appreciate the explanation. I will probably buy the Vanguard Inflation-Adjusted Securities fund for my retirement portfolio.

Bob said...

Scott,

Scott Burns recently wrote an article that stated that TIPS no longer paid on one of their indexed amounts. Do you know anything about this change?

The Best,

Bob Deschner

Scott Grannis said...

I am not aware of any problems with TIPS. They are Treasury bonds so it is almost inconceivable that there would be a problem.