As Inflation Heats Up, How Much Can TIPS Really Help?

August 14, 2008

The huge gap in inflation expectations between the market and CPI readings raises fundamental questions about TIPS' scope and reach. 


With the latest consumer price index showing its biggest leap in 17 years, economic signals seem to bode well for investors of Treasury Inflation-Protected Securities. After all, when prices shoot up, isn't that the time to hold TIPS?

Consider what they're supposed to do for a portfolio. TIPS are designed to offer protection against rises in the Consumer Price Index. Twice a year, the par value of the TIPS bond is adjusted upward at a rate tied to the CPI. The higher the index, the more a TIPS value will be raised.

But in order to compensate for this upward adjustment and inflation protection, TIPS typically pay a lower interest rate than conventional, or nominal, Treasuries.

As of midday Thursday, for instance, a 10-year Treasury note was yielding 3.89%; a similar-termed TIPS bond was yielding some 1.66%. The difference between the two, 2.33%, is referred to as the TIPS' breakeven spread. It reflects what the market expects inflation to be over the next 10 years.

There are exchange-traded funds tracking TIPS, and those funds show a similar pattern. For example, the iShares Lehman TIPS Bond Fund (NYSEArca: TIP) had a 30-day SEC yield of 1.36% through Wednesday. By contrast, the iShares Lehman 7-10 Years Treasury (NYSEArca: IEF) had a yield of 3.86%. From that view, the breakeven inflation for a TIPS position would be slightly higher at 2.5%.

Stark Contrasts

But either way, on a single-issue basis or comparing broad bond portfolios, the differences to the latest government figures are stark. The July CPI reading said inflation had risen 5.6% since the same period a year ago, more than double TIPS' breakeven spread. By that measure, TIPS would appear to be an attractive bargain.

The rub is that questions about the CPI's accuracy in accounting for the full impact of rising prices make the value of TIPS funds less clear, say analysts.

The CPI rate has been bouncing around of late, driven by wide swings in energy prices. Moreover, many believe that the complicated methodology behind the CPI deliberately understates the true level of inflation through techniques like hedonic regression (which adjusts down the imputed cost of goods as the quality rises) and substitution (the idea that consumers will happily substitute one good for another if prices rise too much).

"The crime here is that people think they can protect themselves against inflation by investing in a bond that increases its principal by a flawed inflation gage like the CPI," said Michael Pinto, senior market strategist at Delta Global Advisors.

Joe Clark, a demographics expert and managing partner at Financial Enhancement Group, agrees. "The signs we're seeing in the TIPS market right now are very conflicting," said the Anderson, Ind.-based advisor. "Prior to this latest report on Thursday, the PPI [Producers Price Index] had been running hot while the CPI hadn't been going up much at all."

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