Income Builder - Real Interest Rates and Yields on TIPS

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As their name suggests, Treasury Inflation-Protected Securities (TIPS) are issued by the U.S. Treasury and designed to appeal to investors who want some measure of protection against inflation.  Their return consists of two components:  a current rate of interest plus an inflation adjustment, based upon the change in the Consumer Price Index, which is added to principal every six months.  The current interest rate is therefore equal to the real rate of interest, the return earned over and above the rate of inflation.

Investors often compare the yield on TIPS (which excludes the inflation-adjustment) to the yield on the comparable maturity Treasury security.  This is often called the "breakeven inflation rate."  So for example, on October 24, 2008, the yield on the 1.375% TIPS due July 2018 was 2.97%, while the average yield on the Treasury notes maturing around July 2018 was 4.05%.  Thus, the spread between the two, equal to 108 basis points or 1.08%, is the breakeven inflation rate.  If you believe that inflation, as measured by the CPI, is likely to average more than 1.08% per year over the next ten years, you would earn a higher return with the July 2018 TIPS.  If less, then the straight Treasury Note is a better investment.

With the developing financial crisis and gyration in nominal Treasury rates, the TIPS market has been on a roller coaster over the past year.  The following charts show the change in the TIPS yields, for 5-year and 10-year maturities, since 2003.

Chart 4
Average Weekly Yield on 5-year TIPS

From the summer of 2004, when the Federal Reserve reversed course and began raising the targeted Fed Funds rate, until the summer of 2007, when the Fed ended its rate raising campaign, the yield on TIPS rose steadily.  This suggests (at least to me) that the yield on TIPS, which represents the real rate of interest over and above inflation, typically rises when interest rates are generally rising.  After peaking in the summer of 2007, the rate on TIPS fell steadily, because of the Fed's decision to cut interest rates and also because they were sought out by investors for their relative safety.

Chart 5
Average Weekly Yield on 10-year TIPS

Source:  U.S. Federal Reserve

TIPS yields bottomed out in the spring of 2008 during the height of the Bear Stearns crisis.  Since then, they have risen steadily, despite further rate cuts by the Fed, and quite sharply in recent weeks.  As of October 24, 2008, TIPS yields were at five year highs.

It is quite unusual for TIPS yields to be rising in a low interest rate environment.  The rise in yield is most likely due to the recent decline in commodity prices, especially oil, which will push the CPI lower in the months ahead.  Under the inflation adjustment formula, a falling CPI results in a negative inflation adjustment which reduces the principal due on TIPS bonds. (But the principal cannot be reduced below par value or $1,000 per bond.  For that reason, many investors tend to avoid purchasing older TIPS bonds, which have high levels of accrued inflation adjustment.)  It is also possible, but perhaps less likely, that the TIPS bonds are anticipating an imminent sharp increase in interest rates.

Table 3
TIPS Yields and Spreads Over Treasurys:  Friday, October 24, 2008

Source:  Barron's.
Note:  Bid/Asked prices are quoted in 1/32s.  So the 0.875% TIPS due April 2010 are quoted 92 13/32 bid and 92 14/32 asked.  Bid/Asked prices are also quoted as a percent of accrued principal, given in the far right column.

At current levels, I believe that TIPS are attractive.  For example, the 2% TIPS due April 2012 are yielding 3.8%, nearly twice the yield on the comparable maturity (3 1/2-year) Treasury note.  At Friday's (10/24) closing offer price of 94 7/32, you would effectively pay $1,018.50 per bond (94 7/32% times the accrued principal of $1,080  per bond, which includes the inflation adjustment).  If the CPI drops sharply in the next few months and does not increase for the next 3 1/2 years, you will receive annual interest of $20 per bond (i.e. 2%) plus principal of $1,000 per bond at maturity.  That works out to a minimum yield of 1.45% in a deflationary environment.  If the inflation turns out to be higher, your return will be higher too.

Although I believe that there is better value in other fixed income sectors, TIPS are a good buy now for those seeking the relatively safety of U.S. Treasury notes and some protection against future inflation.

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Updated October 26, 2008

Stephen P. Percoco
Income Builder
P.O. Box 1409
Mashpee, MA  02649
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incomebuilder@larkresearch.com

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