From the November 2008 issue of Wealth Manager Web • Subscribe!

November 1, 2008


Inflation is upwardly mobile again, or at least it was before the financial crisis exploded. Pricing pressures may fade until the economic and financial ills stabilize. Regardless of inflation's future path, the jump in consumer prices in the past several years seems to have caught inflation-indexed Treasuries, a.k.a TIPS, off guard. That has led some observers to question the bonds' merits as inflation hedges. But such worries are misplaced even though TIPS have been less than dependable as a window on prospective inflation.

TIPS stumbled in predicting higher inflation, although some analysts saw it coming, as did the gold market, judging by the skyward bias in the precious metal's price in recent years. But if you were looking for warning signs in years past by analyzing the yield spread between conventional and inflation-indexed Treasuries, you gazed in vain.

The widely monitored gauge of inflation expectations drawn from government bonds has been wrong for much of the 21st century, or so it appeared based on the annual pace of consumer price increases in the first eight months of 2008. The lapse, some analysts complained, is evidence that inflation-indexed Treasuries are flawed.

The truth is more complicated, as it almost always is in finance. As a preview, investors should think twice before abandoning TIPS.

Let's start with the basics. The inflation forecast in question comes by way of the difference in the yield on the conventional 10-year Treasury less the yield on a 10-year inflation-indexed TIPS. This is considered the Treasury market's benchmark inflation forecast. The spread represents the breakeven point for owning conventional vs. inflation-indexed Treasuries, which pay a varying yield based on reported changes in the consumer price index, the most popular albeit less-than-perfect definition of U.S. inflation.

As an illustration, let's say you bought a standard 10-year Treasury at a 4% coupon at issue. On the same day, you also bought a 10-year TIPS at a 3% yield. That leaves a 1% spread. If inflation exceeds 1% over the subsequent 10 years, TIPS will fare better in real (inflation-adjusted) terms compared with the conventional 10-year Note, assuming the securities are held until maturity. But if inflation comes in under 1% over the next decade, the standard Treasury Note will enjoy a real performance edge over TIPS.

The lesson is that the investment results of conventional vs. inflation-indexed Treasuries depend on inflation. As such, the choice of picking one bond or the other is a function of one's inflation forecast. But be careful of how you forecast the future. If the inflation outlook is mined from Treasuries, some degree of suspicion is warranted, as recent history suggests. Does the skepticism also cast aspersions on TIPS and their reliability as an inflation-hedging investment?

The stakes are certainly high in answering correctly, given that the conventional Treasury-TIPS spread is an influential source of inflation expectations generally. That's partly because the expectations are dispensed in real time and reflect bets made with actual dollars. By contrast, opinion-based measures of future inflation (such as the University of Michigan Inflation Expectations Survey) are riskless conjectures because there's no money at stake. No wonder, then, that the Treasury-TIPS spread receives close attention from investors and policy makers, including the dismal scientists at the Federal Reserve.

What, then, are we to make of the fact that this real-time measure of anticipated inflation was running in the 2.0%-to-2.8% range (based on 10-year Treasuries) for the five years through the end of August? That's well below the reported 3.5% annual rise in the consumer price index (CPI) over the same time frame.

The government bond forecast for inflation looks even worse if you consider that the reported annual rate of inflation has been steadily rising in recent years, save for a year-long break through the summer of 2007. As of this past August, CPI rose 5.4% for the previous 12 months--or roughly twice as high as the average inflation forecast embedded in Treasuries for much of the past five years.

"That's a pretty significant disconnect," says Ben Thompson, a principal at Samson Capital Advisors, a New York-based fixed-income boutique catering to high-net-worth and institutional clients.

Does that mean the market-based inflation forecast is irrelevant? Or, perhaps prospective inflation is a lot less threatening than recent history suggests? The sharp drop in crude oil prices this past summer, along with a weakening economy, certainly suggests that pricing pressures are set to ebb.

No one can say for sure, of course. Only time can make definitive judgments about the accuracy of market predictions, leaving investors to decide on a prediction. Meanwhile, this much is clear: The track record of inflation relative to the Treasury-based outlook for prices leaves plenty of questions, including: Is the TIPS market a defective asset class? If so, should investors rethink the use of inflation-indexed Treasuries as a strategic holding in a diversified portfolio strategy?

No, at least not based on the seemingly erroneous inflation forecast spawned by Treasuries in recent years. Even if the Treasury-TIPS spread is faulty, it's not obvious that the problem is tied to inflation-indexed Treasuries. Yes, the market-based forecast of inflation arises from yields on two series of government bonds, but the burden of proof isn't equally distributed.

Recall that TIPS offer investors an opportunity to lock in a real (i.e., inflation adjusted) yield for the life of the bond. If you bought a newly issued 10-year TIPS with a 2% coupon, you're guaranteed to receive that real yield for the next decade if you hold to maturity. Inflation may subsequently soar to hyperinflation or fade to deflation, but the 2% real yield remains intact. To the extent that government guarantees on bonds are reliable in this world, the TIPS real yield is as dependable as it gets.

TIPS, to restate the obvious, are immune from inflation (as defined by CPI). That's the basis of their appeal. Not so for conventional Treasuries, which only guarantee a nominal payout. TIPS, then, are a hedge on rising inflation; a security that allows investors to lock in a real current yield. But how does one square that utilitarian profile with the poor track record of inflation forecasting via Treasuries?

"It's definitely the case that [the Treasury-TIPS spread] underpredicted the inflation we've seen over the last few years," says James Hamilton, an economist at the University of California at San Diego.

Yet a defective inflation forecast isn't a death sentence for TIPS' inflation-hedging capabilities. Anticipated or not, TIPS investors are compensated for any higher-than-expected inflation. As CPI's pace rise, so too do TIPS' payouts--an adjustment that's business as usual for maintaining a real yield.

The future will offer no less an opportunity to hedge inflation, regardless of the accuracy--or inaccuracy--of the overall Treasury market's predictions. In fact, opportunistic investors should be hoping that the Treasury market continues to soft pedal the risk of future inflation.

"If you think inflation over the next 5to 10 years is going to be higher than the breakeven yields seem to say, then you should be buying TIPS and dumping the nominals," Hamilton advises. "If you think that TIPS are underestimating inflation, they're a good buy because you think they'll go up [in price] and experience a bigger [nominal] capital gain than the market expects."

Recall that buying TIPS locks in a real yield, meaning that the nominal yield fluctuates with the CPI trend. That opens the door for bigger-than-expected nominal returns with inflation-indexed Treasuries if the market underprices inflation's potential.

Imagine it's August 30, 2003, and you're considering the breakeven spread for conventional and inflation-indexed government bonds. At the time, the Treasury spread anticipated inflation at just below 2.2% for the decade ahead. Halfway into that forecast (by the end of August 2008), reported inflation was running at about 3.7% a year for the previous five years--or more than two-thirds higher than forecast in August 2003.

The 2003 prediction turned out to be wrong, at least at the five-year mark. Yet it's worth pointing out that the 2003 forecast looked like a reasonable guess at the time. Consumer prices rose just 2.2% for the year through August 2003, or virtually identical to the Treasury breakeven spread at that point.

Reasonable at the time, perhaps, but it still looked wrong in August 2008. But if you think that an erroneous inflation prediction weighed on TIPS as an investment from 2003 through 2008, think again. Consider that the five-year trailing returns for the TIPS-focused Vanguard Inflation Protected Securities mutual fund (VPSIX) handily beat its investment-grade bond counterparts. Even substantially lengthening average maturity and duration in a portfolio of conventional Treasuries was effectively a wash against outdistancing TIPS.

The proof that TIPS can shine even when the Treasury spread forecast stumbles also comes from a more direct comparison of performance via inferring returns based on current yields on August 31, 2003. The 2.29% real yield for 10-year TIPS on that date proved superior compared to the 4.45% for the current yield on the nominal 10-year Treasury--if we fast forward five years and adjust for inflation. Indeed, a 4.45% nominal yield fades to 0.85% after CPI's pace for the five years through August 31, 2008.

If TIPS have done relatively well in the wake of a flawed inflation forecast, who pays the price for the error? Owners of conventional Treasuries, of course, as the inferred real yield analysis above suggests.

"TIPS have proven to be a great inflation hedge because the market forecast for inflation, represented by the [yield] differential has been so consistently wrong," says Timothy Wilhide, comanager of The Hartford Inflation Plus Fund. "It's not the TIPS market that's wrong; it's the nominal market that's overly optimistic on inflation," at least as far as reported CPI goes.

There are a number of theories about why the conventional Treasury yield remained so low in the face of rising inflation. The so-called global savings glut that channels foreign export earnings into Treasuries is one idea; others are rising demand for the safe harbor of Treasuries and optimism that inflation will soon cool.

Whatever the reason, it doesn't change the fact that TIPS function in two capacities. As a partner with conventional Treasuries, TIPS offer a real-time forecast of inflation. TIPS also provide the opportunity to secure a real yield. It's debatable if a given real yield will suffice, but to the extent it does, there's no reason to question its reliability.

Well, almost no reason. There's debate about whether the underlying inflation benchmark adequately compensates for pricing pressures in the real world. But if you accept CPI (or tolerate it), TIPS are a tough act to beat. In fact, they're the true investment benchmark for U.S. investors since they offer the only inflation-hedged yield guarantee that's free of principal risk. Just remember: the guarantee ends there.

James Picerno ( is senior writer at Wealth Manager.

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