TIPS Update: no longer a steal, but they still have appeal
Scott F. Grannis - Economist for Western Asset
January 2001
The 4.4% real yield on TIPS that was briefly available last January proved to be extraordinarily attractive. After a spectacular rally - the TIPS index return of 13.8% last year rivalled the 14.4% on 10-year Treasurys - the yields available today on TIPS are around 3.5%, only slightly higher than their original issue yields of 3.3% back in 1997. What's left to like?
Although TIPS are less attractive today from a real yield perspective, they can still make valuable contributions to investors' portfolios: 1) 3.5% real yields on a default-free bond are still relatively high from an historical perspective. 2) TIPS look cheap relative to Treasurys of comparable maturities. 3) TIPS could be a good hedge to equity and credit exposure in the event of deflation and/or recession. 4) TIPS are still one of the best inflation hedges available. 5) The prospect of lower financing costs in a Fed easing cycle enhances the positive carry of TIPS for leveraged investors and could yield higher TIPS prices.
Chart #2 recaps the ex-post real yield on 10-year Treasurys. After being negative for much of the 1970s, real yields have been substantially positive for the past 20 years. Today's default-free real yields of 3.5% are about average for the past 15 years, but are still attractive from a longer-term perspective and in any event are not inconsiderable - they compound to a guaranteed increase in purchasing power of 41% in 10 years and 180% in 30 years. And in all likelihood, the effective real yield on TIPS is higher than 3.5%, because the consumer price index (which is used to adjust the value of TIPS' principal over time) overstates inflation. The key source of inflation overstatement is the government's estimate of service sector productivity, which has been very low and even negative for many years. Why should service sector productivity be so low, when the manufacturing sector has experienced a virtual explosion of productivity? Since it's almost impossible to measure, government statisticians have likely erred on the side of caution. If we correct for the government's lowball estimates of service sector productivity, measured inflation could drop by as much as 2% per year over the past five years, thus raising the effective real rate on TIPS to 4.5 - 5.5% today.
If you believe the TIPS and Treasury markets are reasonably efficient, then subtracting TIPS real yields from Treasury nominal yields gives a good approximation of the market's expectation for consumer price inflation. As chart #3 shows, Treasurys and TIPS are priced to the assumption that inflation will average only 1.7% per year for the next 10 years, a huge decline from the 3.4% growth of the CPI last year. If inflation were to average anything higher than 1.7%, then 10-year TIPS would produce a total return superior to that of 10-year Treasurys. In other words, TIPS are more attractive than comparable maturity Treasurys - unless you believe CPI inflation is going to be lower than 1.7% for a full 10 years!
The lesson we learned last year is that TIPS aren't just good for inflation hedging - they're good for deflation as well. TIPS have three sources of holding period return: their real coupon, the rate of consumer price inflation, and the change in their price resulting from changes in the market level of real yields. This latter source of return can be quite potent, since the duration of TIPS with respect to changes in real yields is very high: about 8.2 years for a 10-year maturity and 16.9 years for a 28-year maturity. Real yields plunged last year as inflation fears receded, the economy slowed to a crawl, and deflation concerns began to surface. Chart #4 suggests that if the current slowdown were to become protracted, real yields could decline appreciably from current levels.
There are theories which argue that the level of real yields should rise and fall with the strength of the economy. Although this does not always happen in practice, the Fed's modus operandi, which seeks in part to target inflation indirectly by attempting to modulate the economy's growth rate, helps make it happen at major turning points. Rapid growth in '99 and early '00 triggered aggressive rate hikes, which translated into rising real interest rates. This year's slump is already expected to lead to a series of rate cuts, and declining real interest rates, as shown in chart #5.
Still concerned about inflation? That's what TIPS were made for. No other fixed income instrument will deliver a guaranteed real yield plus the rate of CPI inflation. As icing on the cake, TIPS prices would likely rise as inflation rose, since demand for inflation protection would increase. Real estate and gold would likely do well also in a rising inflation environment, but real estate is vulnerable in the short term to the vagaries of the business cycle, and gold pays no coupon in the event inflation remains dormant. The worst-case scenario for TIPS is probably the one we've just lived through: tight monetary policy pushing real yields up and inflation expectations down.
Finally, there is the issue of borrowing costs. TIPS can be financed at essentially the federal funds rate. As chart #6 shows, the real funds rate has usually been lower than real bond yields, meaning that a leveraged position in TIPS typically can be financed with "positive carry." Now that the risk of higher financing costs is turning into the expectation of lower financing costs and better carry prospects, the institutional bid for TIPS could firm up. Indeed, this probably explains at least part of the rally in TIPS since Fed tightening expectations peaked last May.
One final note, which is that TIPS are strippable. So far, though, no buyers have stepped up to the plate. Stripped TIPS would offer the same inflation protection and real yield as regular TIPS, but minus the reinvestment risk. TIPS principal strips should be attractive for those wanting to hedge very long-dated, inflation-sensitive liabilities, since there is virtually no alternative vehicle. It's anticipated that principal-stripped TIPS would trade at a premium to coupon-stripped TIPS, but we'll just have to wait and see.
This publication reflects current opinions of Western Asset Management and is for educational purposes only. Information contained herein, including data supplied by others, is believed to be accurate, but cannot be guaranteed. Opinions represented are neither a recommendation nor an offer of securities and statements in this material should not be considered investment advice. Employees and/or clients of Western Asset Management may have a position in the securities mentioned. This material may not be reproduced in any form without written permission.
Scott F. Grannis - Economist for Western Asset
January 2001
Although TIPS are less attractive today from a real yield perspective, they can still make valuable contributions to investors' portfolios: 1) 3.5% real yields on a default-free bond are still relatively high from an historical perspective. 2) TIPS look cheap relative to Treasurys of comparable maturities. 3) TIPS could be a good hedge to equity and credit exposure in the event of deflation and/or recession. 4) TIPS are still one of the best inflation hedges available. 5) The prospect of lower financing costs in a Fed easing cycle enhances the positive carry of TIPS for leveraged investors and could yield higher TIPS prices.
Chart #2 recaps the ex-post real yield on 10-year Treasurys. After being negative for much of the 1970s, real yields have been substantially positive for the past 20 years. Today's default-free real yields of 3.5% are about average for the past 15 years, but are still attractive from a longer-term perspective and in any event are not inconsiderable - they compound to a guaranteed increase in purchasing power of 41% in 10 years and 180% in 30 years. And in all likelihood, the effective real yield on TIPS is higher than 3.5%, because the consumer price index (which is used to adjust the value of TIPS' principal over time) overstates inflation. The key source of inflation overstatement is the government's estimate of service sector productivity, which has been very low and even negative for many years. Why should service sector productivity be so low, when the manufacturing sector has experienced a virtual explosion of productivity? Since it's almost impossible to measure, government statisticians have likely erred on the side of caution. If we correct for the government's lowball estimates of service sector productivity, measured inflation could drop by as much as 2% per year over the past five years, thus raising the effective real rate on TIPS to 4.5 - 5.5% today.
If you believe the TIPS and Treasury markets are reasonably efficient, then subtracting TIPS real yields from Treasury nominal yields gives a good approximation of the market's expectation for consumer price inflation. As chart #3 shows, Treasurys and TIPS are priced to the assumption that inflation will average only 1.7% per year for the next 10 years, a huge decline from the 3.4% growth of the CPI last year. If inflation were to average anything higher than 1.7%, then 10-year TIPS would produce a total return superior to that of 10-year Treasurys. In other words, TIPS are more attractive than comparable maturity Treasurys - unless you believe CPI inflation is going to be lower than 1.7% for a full 10 years!
The lesson we learned last year is that TIPS aren't just good for inflation hedging - they're good for deflation as well. TIPS have three sources of holding period return: their real coupon, the rate of consumer price inflation, and the change in their price resulting from changes in the market level of real yields. This latter source of return can be quite potent, since the duration of TIPS with respect to changes in real yields is very high: about 8.2 years for a 10-year maturity and 16.9 years for a 28-year maturity. Real yields plunged last year as inflation fears receded, the economy slowed to a crawl, and deflation concerns began to surface. Chart #4 suggests that if the current slowdown were to become protracted, real yields could decline appreciably from current levels.
There are theories which argue that the level of real yields should rise and fall with the strength of the economy. Although this does not always happen in practice, the Fed's modus operandi, which seeks in part to target inflation indirectly by attempting to modulate the economy's growth rate, helps make it happen at major turning points. Rapid growth in '99 and early '00 triggered aggressive rate hikes, which translated into rising real interest rates. This year's slump is already expected to lead to a series of rate cuts, and declining real interest rates, as shown in chart #5.
Still concerned about inflation? That's what TIPS were made for. No other fixed income instrument will deliver a guaranteed real yield plus the rate of CPI inflation. As icing on the cake, TIPS prices would likely rise as inflation rose, since demand for inflation protection would increase. Real estate and gold would likely do well also in a rising inflation environment, but real estate is vulnerable in the short term to the vagaries of the business cycle, and gold pays no coupon in the event inflation remains dormant. The worst-case scenario for TIPS is probably the one we've just lived through: tight monetary policy pushing real yields up and inflation expectations down.
One final note, which is that TIPS are strippable. So far, though, no buyers have stepped up to the plate. Stripped TIPS would offer the same inflation protection and real yield as regular TIPS, but minus the reinvestment risk. TIPS principal strips should be attractive for those wanting to hedge very long-dated, inflation-sensitive liabilities, since there is virtually no alternative vehicle. It's anticipated that principal-stripped TIPS would trade at a premium to coupon-stripped TIPS, but we'll just have to wait and see.
This publication reflects current opinions of Western Asset Management and is for educational purposes only. Information contained herein, including data supplied by others, is believed to be accurate, but cannot be guaranteed. Opinions represented are neither a recommendation nor an offer of securities and statements in this material should not be considered investment advice. Employees and/or clients of Western Asset Management may have a position in the securities mentioned. This material may not be reproduced in any form without written permission.