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Friday, August 3, 2012

How Do Treasury Inflation Protected Securities Work?

Inflation protection is an important challenge for investors over the long term.  Recently, I presented the case of Joe who invested in fixed rate 10-year Treasuries 20 years ago, envisioning a financially secure retirement, and then faced declining rates and purchasing power erosion because of inflation.

One way to protect against inflation is to hold Treasury Inflation Protected Securities (TIPs) issued by the U.S. government.  In one fell swoop, this eliminates credit risk and inflation risk.

One of the most confusing aspects of a TIP is its yield, especially today with many TIPs having a negative yield.  Why would anybody want to invest in an instrument that has a negative yield? Wouldn't that mean that we're paying someone to hold our money?  How does that keep up with inflation?

The answer is pretty simple.  The yield isn't indicative of likely return on your investment.  Let's take a specific example and work through how to analyze TIPs.  From the Bloomberg site we find that the yield on the 10-year Treasury is 1.51% and the yield on the 10 year TIP is -.68%.  Obviously, the 10-year Treasury is the better investment, right?

Not so fast.  The TIP's principle gets adjusted every 6 months by the CPI.  For example, if the principal is $100 and inflation is at an annual rate of 6%, then the principal amount after 6 months is $103 ( 6%/2 = 3% adjustment).  This principal adjustment is not part of the yield calculation!  But the yield is still important, as follows.

To think through the relative investment merits of the two issues, you need to first take their difference in yield (1.51 - (-.68)) which is 2.19%.  If inflation averages greater than 2.19% over the next 10 years, then the 10-year TIP will outperform (because its principle increases at the rate of inflation); otherwise the 10-year Treasury will outperform.

To calculate the yield on a specific TIP, use the calculator at FICALC (read user agreement):

Source: FICALC
The yield is calculated in exactly the same way as a normal bond assuming no inflation adjustment. T hus, if inflation was zero over the period ,the yield would be a negative -.68%. Again, this has to be taken in the context of expected inflation.

To gain a bit more perspective l,ook at the performance data on ETFs in the following table, where AGG represents the entire investment grade U.S. bond market, IEF is indexed to the 7-10 year Treasury curve, and TIP is the TIP ETF :

Source: Yahoo Finance

It is worth noting that the duration of IEF at 7.5 years is considerably greater than AGG (4.36 years) and TIP (4.84 years).  Over the periods shown, the TIP ETF has performed well relative to the other ETFs shown. Especially impressive is the 3-year performance - with a considerably lower duration, it outperformed IEF!

In thinking about investment merit, I suggest start by thinking about the 10-year Treasury.  If your objective is to outperform the 10-year Treasury, you next want to examine whether you think inflation will be greater than the difference in the yield between the 10-year Treasury note and the 10-year TIP. If so, then go with the TIP.  Today, investors expect inflation to average 2.19% over the next 10 years.

As usual, I tend to prefer using ETFs, but here it is worth pointing out that TIPs can be bought at auction at no commission at the same prices paid by the big boys by opening an account at Treasury Direct. 

It is also worth knowing that, if you think yields are headed higher because of inflation, you could be better off avoiding both the 10-year Treasury and its corresponding TIP.  You may want to go to the 5-year TIP ,for example, or avoid the sector altogether and utilize a short duration corporate ETF.

Disclosure:  This information is for educational purposes only.  Investors should do their own research or consult a professional before making investment decisions.

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