TIPS valuation update

This comes in response to a reader's question. TIPS are a bit of a challenge to value, since they have several potentially valuable characteristics: 1) the real yield paid to the investor, 2) the future inflation adjustment paid to the investor, and 3) the change in the market price that may occur (which is determined by the change in the real yield). This chart focuses on the first characteristic, the real yield to maturity of 10-year TIPS, which is a decent proxy for where the TIPS market happens to be. (Right now, short-maturity real yields are about 1%, while long-maturity yields are 2.4%.)

The colored valuation bands on this chart are my creation. I think that on the basis of their current real yield, TIPS are not undervalued, and are actually a bit overvalued.

To step back for a minute, it is important to note that TIPS offer the only real yield that is guaranteed by the U.S. government; it is the coupon paid on TIPS whose face value is adjusted daily (prorata) for changes in the CPI two months earlier. No other security promises a guaranteed return above the rate of inflation. As such, the real yield on TIPS is extremely unlikely to rise beyond the 4-5% level, whereas the nominal yield on Treasuries can theoretically rise without limit. Why? Because the world's investors could not possibly turn down the opportunity to make a 5% guaranteed real yield for 10 years—no asset class could compete with that. Real yields could conceivably fall below zero, however, but I think that would only happen in a scenario in which inflation rose dramatically (into double digit levels) and demand for TIPS proved to be extremely strong. At that point an investor would effectively be giving up some of his inflation adjustment for the privilege of being protected against raging inflation.

As for the second characteristic, TIPS look to me to be cheap relative to Treasuries. That's because the difference between the yield on TIPS and Treasuries of similar maturity (which equates to the market's expectation of future inflation) is only a bit over 2%. The market expects the CPI to average about 2.1% over the next 10 years, whereas it averaged about 2.5% over the past 10 years. I think there's a good chance that inflation will be more than 2.5% on average going forward, so that means that the Treasury market, internally, is undervaluing TIPS. This in turn means that you should prefer TIPS to Treasuries.

As for the third characteristic, I think the likelihood of price gains relative to current prices is low. The one significant risk faced by TIPS investors today, in fact, is that their market price is likely to fall when the Fed starts tightening policy, and especially if they tighten policy sooner than expected.

To sum up, I don't think you are going to make a killing by buying TIPS today, unless inflation truly skyrockets. TIPS are best thought of as a guaranteed way to keep money safe from inflation while also earning a modest real yield. If you currently own Treasuries, you might be wise to trade them in for TIPS. If you currently hold cash as a hedge against risk in general, you might be wise to hold TIPS instead.