In an article on Jan. 9, Wall Street Journal columnist Jason Zweig recommended that investors purchase more Treasury Inflation-Protected Securities (TIPS). That article, and Zweig’s recommendation, has resulted in a lot of questions from both clients and advisors. So I thought I would provide some analysis to help investors make that decision.
We’ll begin by comparing the return on 10-year TIPS to the return on 10-year nominal Treasurys. As I write this on Jan. 13, the yield on 10-year nominal Treasurys was at 1.89 percent, and the yield on 10-year TIPS was at 0.34 percent, which results in a breakeven inflation rate of just 1.55 percent. We can compare that to the current 10-year consensus forecast of inflation from the Federal Reserve Bank of Philadelphia’s Survey of Professional Economists, which is 2.2 percent.
Having a preference for TIPS is a no-brainer.
A Deeper Dive
Before looking at an alternative, it’s important to point out that the spread between the yield for nominal bond and the yield for TIPS doesn’t reflect the market’s expected inflation rate. There are two other factors involved.
The first factor is the liquidity premium in nominal Treasuries, the most liquid investment in the world. The liquidity premium serves to reduce the yield on the nominal bond. The second factor, the risk premium for unexpected inflation, works in the other direction. Thus, the nominal bond yield has three components:
- The real rate (which is the rate on TIPS)
- The expected inflation rate
- And, a risk premium for unexpected inflation
Given the forecast from economists at the Fed of inflation near 2.2 percent and the breakeven inflation rate of just 1.55 percent, it looks like there is a large liquidity premium in the nominal bond and a very small premium for unexpected inflation. That makes TIPS seem highly attractive relative to nominal Treasurys.
The CD Alternative
However, at least for individual investors, there’s another alternative. Investors can purchase 10-year, FDIC-insured CDs which, like Treasurys, entail no credit risk.
The current yield on 10-year CDs is about 3.2 percent. So if we compare the 3.2 percent yield on 10-year CDs to the 0.34 percent yield on 10-year TIPS, we now get a breakeven inflation rate of 2.86 percent. The 2.86 percent breakeven rate compared to the expected inflation rate of 2.2 percent amounts to a 66-basis-point insurance premium for unexpected inflation.
The study “Inflation Risk Premium: Evidence from the TIPS Market” covered the period from 2000 through 2008. Not surprisingly, the authors found that the inflation risk premium is time-varying. However, their estimates of the 10-year inflation risk premium didn’t ever exceed 0.19 percent.
The bottom line is that, relative to 10-year nominal bonds, 10-year TIPS should be strongly preferred. However, if you have the option of purchasing FDIC-insured CDs, TIPS look relatively expensive unless you are highly exposed to the risk of unexpected inflation and willing to pay a relatively high insurance premium. Thus, for many investors, the nominal CD should be the preferred investment.
Larry Swedroe is the director of research for the BAM Alliance, a community of more than 150 independent registered investment advisors throughout the country.