Swedroe: Understanding TIPS

December 07, 2018

Allocating To Inflation-Protected Securities

The academic research, including the 2004 study “Asset Allocation with Inflation-Protected Bonds,” the 2006 study “Diversification Benefits of Treasury Inflation Protected Securities: An Empirical Puzzle” and the 2016 study “Residual Inflation Risk,” makes the case that, because of their diversification benefits, unless the risk premium for unexpected inflation is large, investors should strongly prefer TIPS. This is especially true for investors vulnerable to inflation (such as retirees living on a fixed income).

The only question left appears to be how large a premium is required before investors might prefer nominal bonds. In fact, Philipp Illeditsch, author of “Residual Inflation Risk,” concluded that “investors should hold a zero-investment portfolio of nominal bonds.”

In my opinion, that’s too extreme a statement, especially for investors who have more ability to bear the risk of unexpected inflation. For example, for investors still in the workforce, real wages tend to keep up with inflation.

S.P. Kothari and Jay Shanken, authors of “Asset Allocation with Inflation-Protected Bonds,” looked at this issue too, specifically in terms of five-year maturities. They concluded that the preference for inflation-protected securities is so strong that if there is no inflation risk premium, the optimal allocation to them is 80%. Even with an inflation risk premium of 50 basis points, the optimal allocation is 60%.

The bottom line is this: Given that investors in TIPS are not currently sacrificing any expected return (in fact, they have a higher expected return), they should greatly prefer five-year TIPS to five-year Treasuries.

Alternatives To Mutual Funds

Now let’s look at the issue when the investor has the ability to buy individual bonds. Because neither bond investment incurs any credit risk, there is no need to diversify risk. Thus, the main benefit of a mutual fund is no longer relevant.

As long as investors are willing to sacrifice the conveniences of a fund (such as the ability to automatically reinvest interest), they can buy individual certificates of deposit (CDs) instead of a Treasury bond or a Treasury bond fund. FDIC-insured CDs typically carry significantly higher yields than Treasuries of the same maturity—which is why my firm, Buckingham Strategic Wealth, generally buys them instead of nominal Treasuries when building laddered portfolios.

As I write this, the yield on a five-year CD is about 3.6%. With the five-year TIPS yielding 1.07%, the breakeven inflation rate is 2.53%. Subtracting from that figure the 2.21% estimated rate of inflation from the Federal Reserve Bank of Philadelphia’s survey of forecasters, we arrive at a premium of 0.32%.

For investors less susceptible to risks associated with unexpected inflation, a premium favoring CDs of 0.32% a year certainly is worth considering, especially because the maturity in this case is not very long (the risk of unexpected inflation rises as maturity increases).

With a premium of this size, investors who can accept the risk of unexpected inflation should at least think about allocating some significant portion of their fixed-income portfolio to nominal CDs.

On the other hand, if we use the higher 2.34% inflation estimate provided by the swaps market, we have a premium favoring CDs of only 0.19 (2.53 – 2.34)%. At that level, while it still seems worth considering, TIPS likely should be the choice for all but aggressive investors able to accept the risk of unexpected inflation.

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