Treasury Inflation Protected Securities

Real Yield – measured by subtracting inflation from nominal yield – is an extremely important factor in fixed income investing. High inflation not only destroys purchasing power but is also greatly influences investor behavior. Traditionally investors will demand higher rates of interest as inflation creeps higher in order to preserve their purchasing power. However, as the graph below shows, negative real interest rates are not impossible.

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While year-on-year inflation, as measured by the Consumer Price Index, was 12.3% in December of 1974, the prevailing yield on the ten-year Treasury was at 7.4%, a real yield of -4.9%. A similar situation happened again just a few years later. By the mid-80’s inflation had calmed down, but Treasury yields remained elevated. Real yield on the Ten-year Treasury reached a record 9.5% as investors sought revenge for the past decade of poor inflation adjusted returns. This all happened without the presence of TIPS.

When they were introduced in 1997 Treasury Inflation Protected Securities changed the landscape of investing. While still maintaining the full faith and credit of The US Government, investors are now given the option of accepting a lower coupon in exchange for future adjustments to principal based on CPI. TIPS trade on a yield basis, just like any other bond, but if you assume CPI accurately measures inflation, the quoted TIPS yield is a real yield. If you don’t, please take a number… the Bureau of Labor Statistics will be with you shortly.

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The first few years of TIPS data isn’t very reliable. In December 1997, after one full year of TIPS issuance, the total market value of TIPS was $33 billion, less than 1% of the $3.5 trillion Treasury market at the time. By 2000 the value was still only at 3.5% of the market. TIPS have ballooned to $551 billion (about 8%), and now that it has been around for a while, it operates much more efficiently. This is the main explanation for the elevated yields from 1997 to 2000.

Some argue that TIPS won’t provide the inflation protection they advertise when the Fed moves to nip inflation in the bud, saying that when inflation begins to go away, the absolute return of TIPS (real yield + inflation) will be diminished. But is that important? If you buy TIPS, do you necessarily want runaway inflation? If you are looking to spend the dollars you are investing on real goods at some point in the future, the inflation portion of your return will be offset by the run up in prices of real goods. Leaving you with an effective hedge against what would otherwise hurt your return.

Secondly, a certain author of a certain Wall Street Journal article argues that a shift toward tight money from the Fed will move so many investors out of TIPS, driving prices for the securities down, that any benefit will be negated. The graph above shows the movement in TIPS yield that happened as a result of the world moving from $150 per barrel oil in the summer of 2008 to the largest deflationary scare in the Post WW2 era. (A pretty serious adjustment) This movement from 1.5 to 3% in TIPS translates into a 14% decline in the price of the 10-year TIP, while the nominal 10-year was up about 16% over the same period. So that means we should all load up on ten year Treasurys at 3.30% right?

Diversification is key to any sound investment strategy and the correlation of TIPS with other asset classes is attractive to investors. It is the unique characteristics of TIPS compared to other asset classes that provide this benefit, along with unique risks.

Cliff J. Reynolds Jr., Investment Analyst