cheaper at the moment
Last Friday’s column covered the calamity known as “the 2022 market in inflation-protected Treasury securities.” Facing the first serious bout of inflation in its 25-year history, the investment designed to hedge against inflation quickly gave out. Medium-term TIPS are down 12% on the year, and their longer-term cousins are down even more.
On the other hand, out of disaster comes opportunity. Perhaps the TIPS have dropped enough to become compelling. This column approaches the issue from two perspectives: 1) as a buy-and-hold investment and 2) as a market value. In the first case, the main question is: “If I keep TIPS for 10 years, will I be satisfied with my decision?” In the second, the question is whether TIPS will still get cheaper. If so, there’s no point in buying TIPS now, as they may soon cost even less.
buy and hold
The first angle is easy to tackle. Unusually, TIPS have explicit real returns. The underlying mechanics defy simple explanation, because market movements affect the calculations (for example, a security initially issued with a positive real yield may change in price to have a negative real yield), but suffice it to say that the yield after inflation for TIPS to be held until maturity is known in advance. (Not exactly because of the reinvestment risk, but close enough for a blogger.)
Currently, the amount of a 10-year TIPS is 1.6%. Buy a freshly issued 10-year TIPS, put it away in an electronic locker, and within a decade, that security will have returned an annualized percentage of 1.6 points above the rate of inflation, as determined by the unadjusted version of the consumer’s price index. (Again, this account is the shortened version of a longer but substantially similar story.)
We can compare that 1.6% figure to what conventional 10-year Treasuries have historically earned. Since 10-year Treasury bonds debuted in 1953, I began my research in January 1960. Thereafter, I calculated the real annualized return each decade for such securities, assuming they were purchased at the beginning of the decade and held until expiration. Therefore, the bar labeled “1960s” represents a 10-year Treasury note bought in January 1960 and sold in January 1970.
At first glance, TIPS do not look cheap. In three of the six decades, its natural investment rival, conventional 10-year Treasuries, has returned much higher than today’s TIPS. Twice the results were similar. Only once, during the 1970s, would the actual yield on today’s TIPS have exceeded what conventional Treasuries ultimately produced.
The next look is happier. Conventional Treasuries were great through the 1980s, 1990s, and 2000s, but only because their yields topped 6.5% at the start of each period. That condition no longer exists. Based on current conventional Treasury yields, the 1960s and 2010s are the most relevant comparisons. During those times, TIPS were fully competitive while at the same time protecting against unexpectedly high inflation.
In short, 10-year TIPS are more attractive than their conventional Treasury competitors. That wasn’t the case a year ago, when his real returns were negative, but the scales have tipped in his favor, no pun intended. (A case could also be made for a strategy of combining the two investments, such that the guaranteed portion of an investor’s future returns receives both nominal and inflation-adjusted returns, but that is a topic for another column.)
The next 12 months
Now let’s move on to the consideration of whether TIPS have to fall further. Doing so means thinking about how TIPS are priced. As noted above, the return on TIPS comes from two sources: 1) inflation and 2) the real return. Although inflation cannot be known in advance, we can calculate its expected rate by subtracting the real yield on TIPS from the nominal yield on a conventional Treasury of the same maturity. What remains is the inflation expectation of the market, more or less.
Presumably, that implied inflation number fluctuates wildly; after all, most people now see inflation as a much bigger threat than they did three years ago. However, as the chart below shows, the implicit inflation rate has remained relatively stable. It plummeted during the two recessionary crises of 2008 and 2020, but has otherwise been constantly hovering between 1.5% and 2.5%.
While it’s easy to understand how inflation expectations change, it’s hard to imagine why real TIPS yields move. Why would investors demand a 1% real yield on a 10-year US government-guaranteed bond, which means questions about its creditworthiness should never affect its price, in a moment, but would accept much less another time? After all, the pool of investors hardly changes from year to year, and neither does aggregate investment demand.
This chart is much more volatile than the previous one. From 2003 to 2010, this chart (coincidentally) occupies pretty much the same territory as the implicit inflation chart, fluctuating between 1.5% and 2.5%, but during 2010 it falls below 1% and has stayed there until recently. very little. In addition, on two occasions the actual return turns significantly negative.
In general, actual TIPS returns have been surprisingly volatile, for reasons that experts can only explain after the fact. (Few if any observers warned in 2021 that TIPS could suffer if the Federal Reserve rapidly raised interest rates.) Today’s real returns are high compared to recent history. That is a positive sign for TIPS, as a drop in real yields would boost their prices. But actual returns are still low compared to pre-2010 standards, and who’s to say that such a yardstick hasn’t become the new normal?
Until last week, I hadn’t written about TIPS, partly because I usually talk about stocks, but also because I’ve never been tempted to. Since this column began in 2013, the real return on TIPS has always been below 1%. No more. Consequently, TIPS have become an attractive buy-and-hold investment. However, as their real returns are likely to fall as well as rise, TIPS remain risky for investors who may need liquidity. It would probably be better to keep cash.
This article has been corrected to note that the actual performance of TIPS since 2013 has not always been negative. It had always been below 1%.