HardAssetsInvestor

Written by Eli Neusner  |

February 02, 2009

All About TIPS

Details

Many investors buy commodities looking for protection from inflation. TIPS offer an alternative, or can be used in conjunction with
commodities to achieve a double 'real return.'

• How TIPS work – and why they're cheap right now
• What they're saying about inflation over the next 10 years
• Pairing them with commodities

Treasury Inflation-Protected Securities (TIPS) do exactly what their name suggests. They are U.S. Treasury bonds designed specifically to protect investors against inflation. To do that, both the interest and the principal payments are indexed against the Consumer Price Index. So the yield quoted on a TIPS security is a "real" return; that is, an incremental return that's added to the rate of inflation. Like other Treasuries, TIPS pay interest every six months and pay the principal when the security matures. The difference is that the coupon payments and underlying principal are automatically increased to compensate for inflation.

TIPS are not an insignificant part of the fixed-income market. According to the New York Federal Reserve, as of July 31, 2008, TIPS outstanding totaled over $515 billion; or about 11% of marketable Treasuries outstanding. Average daily trading volume of TIPS by primary dealers in 2008 is close to $9 billion. That number is going to grow – just this week, $8 billion worth of 20-year TIPS went up for sale, which could potentially drive down yields in the short term.

TIPS can be used to market-time your expectations regarding inflation. To accomplish this, one must understand how to determine the embedded inflation expectation in TIPS. This can easily be done by comparing a TIPS' yield to that of a nominal U.S. Treasury bond. For example, if a nominal 10-year Treasury bond is priced with a yield to maturity (YTM) of 5%, and a similar TIPS is priced with a YTM of 2.5%, the implied inflation expectation would be 2.5%.

Using the example, if an investor believes inflation will actually move upward to 3.5%, that investor would buy a TIPS because it will become more valuable if actual inflation is greater than what the market expected. Conversely, if an investor believes inflation will be lower than 2.5%, or that deflation will occur, the investor will sell his or her existing TIPS.

Until very recently, TIPS prices seemed to suggest that future inflation would be practically nonexistent. A 10-year TIPS note was yielding between 2-2.5%, while a regular 10-year Treasury note yielded only one-half percentage point more. That means that over the next 10 years, TIPS will do better than regular Treasuries if inflation is more than a mere 0.5% a year. A five-year TIPS note that yielded 2.25% was only slightly more than regular Treasuries. In other words, even if there is no inflation over the next five years, TIPS will earn about the same as standard Treasuries.

What accounted for this unusual state of affairs? First, the bond market was expecting deflation, i.e., falling prices. Gasoline prices are down close to 60% from last July, and consumers are still cutting spending. That drives prices down sharply.

Then there are the hedge funds. When the economy was stronger, many hedge funds loaded up on TIPS, often using borrowed money hoping to cash in on inflation. When investors started cashing out of hedge funds last year, their managers dumped TIPS – not because they wanted to, but because they could sell them easily to raise cash and pay the investors.