Swedroe: Understanding TIPS

December 07, 2018

I’ve been getting lots of questions lately about the merits of owning Treasury inflation-protected securities (TIPS) versus nominal bonds. With that in mind, today I’ll discuss how to determine whether to own TIPS or nominal fixed-income securities.

To begin, we need to recognize there are two ways one can hold TIPS and nominal bonds: purchase the bonds individually, or invest in mutual funds/exchange-traded funds (ETFs). When investing through taxable accounts and IRAs, one can do either. However, in corporate retirement plans, such as a 401(k), one is limited to funds.

To keep the analysis simple, I’ll analyze TIPS and nominal Treasuries with five-year maturities. (The same analysis can be done for other maturities.) As of this writing, Dec. 3, 2018, the five-year TIPS was yielding 1.07% and the five-year nominal Treasury was yielding 2.83%. Thus, the breakeven inflation rate was just 1.76%. It’s important to understand why that does not mean the market is estimating future inflation of 1.76%.

There are two reasons you cannot make that assumption. The first is that nominal Treasury bonds are the most liquid market in the world. While TIPS are relatively liquid securities, and also carry the full faith and credit of the U.S. government, they are not as liquid as nominal Treasury bonds. Thus, investors in nominal Treasuries pay a premium (in the form of a lower yield) to own them. The second is that the yield on nominal Treasuries has three, not two, components: the real yield, the expected rate of inflation and a risk premium for unexpected inflation. TIPS yields are determined only by the real yield.

Observe that the liquidity premium (which depresses yields) and the risk premium for unexpected inflation (which increases yields) work in opposite directions and may cancel each other out. If that is the case, the TIPS-to-nominal-bond spread is a good indicator of the market’s aggregate view of expected inflation.

Philly Fed Survey

To obtain an estimate of expected inflation, we might use the Federal Reserve Bank of Philadelphia’s Survey of Professional Forecasters. This survey is the oldest quarterly survey of macroeconomic forecasts in the U.S. It began in 1968 and first was conducted by the American Statistical Association and the National Bureau of Economic Research. The Federal Reserve Bank of Philadelphia took over the survey in 1990.

Those making forecasts include more than 50 economists from many of the leading financial and research institutions in the country. Their views help shape opinions about expectations for inflation. And they are a consensus forecast—the “wisdom of the crowd.” You can find the complete list of participants within the survey.

The survey’s fourth-quarter 2018 estimate for inflation over the next 10 years is 2.21%, which is 0.45 percentage points higher than the breakeven inflation rate of 1.76% obtained by comparing the yields on TIPS and nominal Treasuries. (Note that the survey’s forecast for the period ending 2022 is very similar, at 2.25%).

Thus, ignoring the liquidity premium, instead of having to pay a premium to hedge the risk of unexpected inflation, investors are actually being paid a premium (about 0.45%). How often do you get paid to avoid risk?

An alternative method is to use the five-year inflation swap rate. The inflation swap’s current market price is 2.34%. Using 2.34% as the inflation estimate provides an expected return on five-year TIPS of 3.41%, or 0.58 percentage points more than on the nominal Treasury yield of 2.83%. The negative premium of 0.58 percentage points makes TIPS the obvious choice.

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