Doing The Math
As I write this, the yield on a five-year CD was 3.4%. With the five-year TIPS yielding 0.77%, the breakeven inflation rate becomes 2.63%.
Subtracting from that figure the 2.2% estimated rate of inflation from the Federal Reserve Bank of Philadelphia’s survey of forecasters, we arrive at a premium of about 0.4%.
For investors less susceptible to risks associated with unexpected inflation, a premium of 0.4% 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 other hand, if we use the 2.4% inflation estimate provided by the swaps market, we have a premium of only about 0.2%. At that level, TIPS likely should be the choice for all but the most aggressive investors able to accept the risk of unexpected inflation.
Misconceptions About TIPS
Before closing, I’ll take the opportunity to dispel a few misconceptions I hear about TIPS.
One common objection I hear to buying TIPS is that a good way to mitigate inflation risk is to use short-term bonds. Unfortunately, this is true only relative to longer-term bonds. Short-term bonds don’t hedge inflation risk as well as TIPS, and the comparison is not even close. The reason is that when inflation rises, the yields on short-term bonds do not immediately respond to the change in expectations.
Consider the following example. For the period 1933 through 1951, one-month Treasury bills produced negative real returns in all but three of those 19 years and an annualized real return of -3.2%. Beginning in 2002, we have seen a repeat performance, with one-month, three-month and one-year Treasuries producing negative real returns in all but three (2006-2008) of the following 16 years.
The annualized real returns over that 16-year period for one-month, three-month and one-year Treasuries were -0.9%, -0.9% and -0.4%. And that was with a CPI of just 2.1%.
Do Rates Need To Rise For TIPS?
Another common objection I hear to buying TIPS involves the expectation that real rates must rise. Thus, an investment in TIPS will suffer. First, investors, including the once-acclaimed “Bond King” Bill Gross, have been forecasting rising rates for quite a while, and they have been dead wrong. That forecast cost them dearly, as they lost an opportunity to earn the term premium and rates first fell further.
In addition, they have remained at historically low levels for far longer than anyone had expected. However, the issue is basically irrelevant, because if you are confident that real rates are going to rise, you can simply buy short-term TIPS and avoid, or minimize, the term risk.
There are now even short-term TIPS ETFs, such as the PIMCO 1-5 Year US TIPS Index ETF (STPZ), with an average maturity of about just three years, and the Vanguard Short-Term Inflation-Protected Securities ETF (VTIP), with an average maturity of about just 2 1/2 years, available for investors who don’t wish to buy individual securities (which can be purchased for any maturity).
Another important point to consider is that if the market also expects real rates to rise, that expectation will already be reflected in the yield curve. Therefore, staying short only helps if rates rise more than is already anticipated by the market.
Not understanding this relationship is a common and costly mistake made by investors and advisors alike—along with the error of thinking they can forecast rates better than the market.
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.