Thursday, November 20, 2008

TIPS are a steal (3)

So many things are cheap today it's hard to know where to start. I highlight TIPS because they represent a unique asset class, and they don't get much attention. TIPS today offer a real yield of more than 3%, guaranteed by the US government, for the next 10 years. That's very attractive, since there are not many 10-year periods in the past in which you could have earned a 3% annual real yield, and that's after the fact. Now you can lock in a 3% real return for the next 10 years with TIPS.

TIPS also offer to pay you whatever the rate of consumer price inflation happens to be. And if you buy a recently issued TIPS and hold it to maturity, you are protected against deflation. If Treasury bond yields ever rise from their incredibly low levels of today, TIPS yields are likely to fall, and that will further boost the return you get on owning TIPS going forward. Why? Because Treasury yields are likely to rise if and when the economy recovers. A recovering economy will quench the current fears of deflation and make inflation hedges like TIPS more attractive, and that in turn will mean lower real yields and higher TIPS prices.

TIPS today are cheap mainly because the market believes that inflation will be nonexistent over the next 10 years. That's the red line in the second chart, the difference between 10-year TIPS yields and 10-year Treasury yields. I've pointed this out before and it bears repeating: the bond market has been underestimating inflation for the past 10 years, and there's a good chance it is underestimating future inflation. The Fed is trying as hard as it can to reflate. Bernanke's career reputation rests on his ability to avoid deflation. Yet the bond market is anticipating deflation will be with us for at least the next several years. In my experience, I think you can never underestimate the ability of the Fed to get what it wants.

Buying individual TIPS can be expensive for small investors due to big bid/ask spreads. You might consider instead a mutual fund such as the iShares Lehman US Treasury Inflation Protected Securities Fund (TIP).

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