SMI Visitor's Blog       

Welcome to the SMI Visitor's Blog where you'll find selected excerpts from our Member's Blog, plus occasional posts created especially for our visitors.

For SMI Web Members, click here to go to the SMI Member Blog.

« Blog Home

TIPS update

At a big investing conference last week in Chicago, PIMCO chief Bill Gross made a compelling case that Treasury yields have fallen so low that it's difficult to see how they'll earn much for investors over the next few years — especially if inflation levels that many expect come to fruition. (PIMCO runs the world's largest bond fund, PIMCO Total Return.)

Gross's comments brought to mind an article I'd read a month ago, but hadn't commented on. Provocatively titled, Holding TIPS Will Make You Poorer, author Brett Arends painted an extremely grim outlook for short-term TIPS bonds.

First, a quick refresher for those who aren't clear on exactly what TIPS (Treasury Inflation-Protected Securities) are or how they work.

TIPS are inflation-protected versions of U.S. treasury bonds. They pay a lower yield than a regular Treasury bond of the same length, but also pay the owner the official rate of inflation during that time.

So, for example, if a 10-year Treasury was yielding 3.0%, a 10-year TIPS bond might yield around 1.2% at a time when official CPI inflation was running 1.6%. That TIPS owner would expect to earn the 1.2% base yield plus the 1.6% inflation yield, for a total of 2.8%. The relationships are never exactly precise, which reflects the bond market's fear (or lack thereof) of future inflation at the moment.

Back to Arends' column. His point was that with real (after-inflation) yields on short-term TIPS having gone negative (investors would earn the inflation rate minus a small amount), these short-term TIPS were almost sure to be losers going forward.

Ironically, after pulling that article up last week in order to comment on it, I came across a new column by the same author. This column's subtitle is Some TIPS Bonds May Still Offer a Decent Deal. Now this may seem double-minded and unstable in all his ways, but it's really not. (Arends is actually one of my favorite columnists because he consistently makes interesting and well-reasoned points.)

The summary of this latest column is that while short-term TIPS look like a bad deal due to their incredibly low interest rates (especially if rates are set to rise, as Gross contends), longer-term TIPS don't look so bad. In fact, when you factor in that they protect against inflation on the one hand, and deflation on the other (via the Treasury promising to pay back at least their face value at maturity), they hold some particular appeal at a moment in time when inflation still seems like a distinct possibility, yet softening economic indicators have reawakened deflationary fears that another recession could be looming.

It's worth noting that both of Arends' columns seem to assume that investors will buy and hold individual TIPS bonds until maturity. That's not likely the case with most SMI readers, who are more likely to own TIPS through a mutual fund. The Gross/Arends arguments also seem to assume an investment time frame of at least the next several years. They are primarily arguing that buyers of these bonds today are going to get hurt as they hold them over the next several years.

It's worth noting that while people have been negative on Treasuries for quite a while, Treasuries have continued to defy expectations and rally this year. So have TIPS. In fact, while many would have said at the beginning of the year that Treasuries/TIPS have nowhere to go but down, a Vanguard fund focused on TIPS is already up 5.02% year-to-date. That's a healthy full-year return earned in less than half a year. Now it's entirely possible that entire gain could evaporate over the next six months — we certainly don't know what the future holds. The point is simply that the length of the current Treasury rally has already surprised most experts, making it difficult to predict how long it may last.

In summary, TIPS still have some appeal. But given their current valuations and today's extremely low interest rates, along other external factors (debt-ceiling impasse, end of the Fed's QE2 policy), that appeal appears to be significantly lower than usual.

Powered by Movable Type  |   Subscribe  |   Email Updates