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Makin' Money

To TIP or not to TIP

Chris Farrell May 9, 2011

The Marketwatch headline grabbed my attention: Holding TIPS will make you poorer. It’s by columnist Brett Arends.

Would you buy an investment that was absolutely guaranteed to lose money?
No ifs, ands or buts: This sucker will make you poorer! How’s that sound?

I’m a fan of TIPS or Treasury Inflation Protected Securities. The creditworthy security is the long-term savers’ friend.

One of the biggest risks faced by savers is that inflation will erode the value of their money over time. Inflation-indexed bonds come in 5, 10 and 30 year maturities. TIPS offer a fixed interest rate above inflation, as measured by the consumer price index. An additional advantage of TIPS is that they protect against deflation–a decline in the overall price level of goods and services–by offering a “deflation floor” that protects principal value during deflation.

Arends scorn is targeted at the 5-year TIPS, although he doesn’t especially like the longer dated ones, either. It’s an intriguing argument, but I’m not convinced that investing in TIPS will make you poorer–especially after considering comparable bond market alternatives.

He doesn’t like 5-year TIPS for a good reason: The after-inflation yield is negative. It’s minus by almost half a percentage point a year.

In other words, under almost any possible scenario, these bonds are guaranteed to lose you nearly half a percent of your purchasing power, each year, for the next five years — a total loss of 2.5%,
It’s crazy. Totally nuts.
Some investment losses are unavoidable, but not this one. This one is a lock. Just take some money from your pocket and throw it away. In football terms, this isn’t playing defense. This is taking a safety. Give up points.

The case for TIPS is strong under most circumstances, but it could still be a lousy investment at the moment.

Here’s the thing: I’m an inflation optimist. But many economists reasonably fear that inflation could go much higher once the economy gains traction. What if my inflation outlook is wrong and the inflation worriers are right?

I contacted Zvi Bodie, finance professor at Boston University,. to get his insight. The co-author of Worry Free Investing he is a well-known advocate of TIPS in retirement portfolios.

Bodie’s starting point is the uncertainty about future rates of inflation:

There is nothing irrational about investing some of one’s wealth in TIPS at a negative real interest rate in order to eliminate this uncertainty. It simply means that a part of one’s principal has to be given up to guarantee that the rest of it will maintain its purchasing power — no matter how high inflation turns out to be.

How does this work out in numbers? Bodie notes that on May 6th the “real” or inflation-adjusted yield on 5-year TIPS was -.07%. The “nominal” yield on a traditional 5-year U.S. Treasury security was 2.17%. (A nominal yield is the published yield; it isn’t adjusted for inflation.) Let’s say a conservative has $100,000 to invest and she wants to maintain at least some of the current purchasing power of her wealth over the next 5 years. She will have have locked in $99,651 in today’s dollars (before taxes) regardless of the rate of inflation, says Bodie.

Now, let’s say she instead puts the $100,000 into 5-year regular Treasuries that yielded 2.17 on May 6th. If inflation runs below 2.24% per year, the conventional Treasury will produce a higher return than the TIPS. But TIPS will do better if inflation exceeds 2.24% a year. For instance, if inflation turns out to be 3% per year she will wind up with $96,035 in today’s purchasing power 5 years from now. At 4%, it’s $91,506. Says Bodie:

The point is that TIPS guarantee a known return in terms of consumer purchasing power regardless of the actual rate of inflation. That makes TIPS the safest way to preserve the purchasing power of one’s wealth over the next 5 years.

I looked at the year-to-date performance of two well-known mutual funds that invest primarily in inflation-protected securities. The year-to-date total return for the Vanguard inflation-protected mutual fund portfolio (VIPSX) was 4.5% and the TIAA-CREF inflation-protected fund (TCILX) was 4.7%. Not bad.

Here’s a different point of view: Most bonds don’t look like good investments with today’s low rates and a strengthening economy. Yet for comparable securities TIPS may still trump the bond market competition. (In the current environment for fixed income securities I still like the dafety of short-term Treasuries, as longer-term TIPS).

What do you think?

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