Loading...
Symbols:
Authors:

Runaway Inflation: Do TIPS Really Help?

by: Index Universe August 15, 2008 | about stocks: CUT / DJP / GLD / GSP / IPE / TIP    
Index Universe

Index Universe

From Index Universe:
Inside ETFs
JOI
Free subscription for US Financial Professionals ETFR
Subscribe now: $279/year
Become a Contributor Submit an Article
  • Font Size:
  • Print

By Murray Coleman

With the latest consumer price index showing its biggest leap in 17 years, economic signals seem to bode well for investors of Treasury Inflation-Protected Securities. After all, when prices shoot up, isn't that the time to hold TIPS?

Consider what they're supposed to do for a portfolio. TIPS are designed to offer protection against rises in the Consumer Price Index. Twice a year, the par value of the TIPS bond is adjusted upward at a rate tied to the CPI. The higher the index, the more a TIPS value will be raised.

But in order to compensate for this upward adjustment and inflation protection, TIPS typically pay a lower interest rate than conventional, or nominal, Treasuries.

As of mid-day Thursday, for instance, a 10-year Treasury note was yielding 3.89%; a similar-termed TIPS bond was yielding some 1.66%. The difference between the two, 2.33%, is referred to as the TIPS' break-even spread. It reflects what the market expects inflation to be over the next 10 years.

There are exchange-traded funds tracking TIPS, and those funds show a similar pattern. For example, the iShares Lehman TIPS Bond Fund (NYSE: TIP) had a 30-day SEC yield of 1.36% through Wednesday. By contrast, the iShares Lehman 7-10 Years Treasury (NYSE Arca: IEF) had a yield of 3.86%. From that view, the break-even inflation for a TIPS position would be slightly higher at 2.5%.

Stark Contrasts

But either way, on a single-issue basis or comparing broad bond portfolios, the differences are stark to the latest government figures. The July CPI reading said inflation had risen 5.6% since the same period a year ago, more than double TIPS' break-even spread. By that measure, TIPS would appear to be an attractive bargain.

The rub is that questions about the CPI's accuracy in accounting for the full impact of rising prices make the value of TIPS funds less clear, say analysts.

The CPI rate has been bouncing around of late, driven by wide swings in energy prices. Moreover, many believe that the complicated methodology behind the CPI deliberately understates the true level of inflation through techniques like hedonic regression (which adjusts down the imputed cost of goods as the quality rises) and substitution (the idea that consumers will happily substitute one good for another if prices rise too much).

"The crime here is that people think they can protect themselves against inflation by investing in a bond that increases its principal by a flawed inflation gage like the CPI," said Michael Pinto, senior market strategist at Delta Global Advisors.

Joe Clark, a demographics expert and managing partner at the Financial Enhancement Group, agrees. "The signs we're seeing in the TIPS market right now are very conflicting," said the Anderson, Ind.-based advisor. "Prior to this latest report on Thursday, the PPI (Producers Price Index) had been running hot while the CPI hadn't been going up much at all."

That meant companies had been reporting higher raw materials prices but not passing those higher costs along to consumers. "But now that the CPI has really jumped, inflation is bound to receive more attention from both consumers and investors," Clark said.

And he doubts that July's CPI reading will be a one-month phenomenon. But such inflation concerns are likely to be tempered somewhat over time, he added. "While some goods and services are clearly going to be more expensive, others are clearly going to be cheaper," Clark said.

Even though investors should expect inflation to rise, he says "it doesn't appear to be one of massive hyper-inflation that would most benefit an ETF" like the iShares Treasury Inflation-Protected Securities Fund (NYSEArca: TIP).

As a result, Clark's in no hurry to jump into TIPS right now, preferring other forms of high-quality bonds. But he's sticking with existing positions for clients in TIPS funds, particularly inflation-protected certificates of deposits. "They work much like a TIPs fund. But a CD will protect your principal as well, which is appealing to more conservative investors interested in holding TIPS as part of their long-term allocation strategy," Clark said.

Ben Jacoby, a founder of Brinton Eaton Wealth Advisors, believes that at least some TIPS deserve to be in long-term investors' portfolios.

"But they offer only marginal protection," said the Morristown, N.J.-based advisor. "There are more direct and efficient ways to hedge against inflation."

Inflation-Hedging Tools

Choosing some good commodities funds is probably a stronger option than just relying on TIPS, Jacobs says. For his clients, he uses the iPath S&P GSCI Total Return ETN (NYSE: GSP). "It's an ETN (exchange-traded note) so it guarantees you the return of the underlying index," Jacoby said. "And GSP has lower expenses than actively managed mutual funds."

He warns that the ETN's index is very aggressive with almost two-thirds of its underlying components in energy. For more conservative investors, Jacoby suggests iPath Dow Jones-AIG Commodity Index ETN (NYSE: DJP). "It follows a broad index with no more than any one commodity being 33%," he said. "So it tends to be less volatile than GSP."

He's also investing in the Claymore/Clear Global Timber ETF (AMEX: CUT). "What we like about timber is that even if the economy isn't doing well, you don't have to harvest the field," Jacoby said. "Also, everything you invest in will probably be counted as long-term capital gains, which is another advantage to timber."

Strategist Pinto likes gold as the best hedge against inflation right now. That's even though it has undergone a double-digit correction. Since its 52-week peak in late March, the price of SPDR Gold Shares (NYSE: GLD) has dropped about 20%.

"This would be a wonderful time for investors who were afraid to buy a gold fund when it was at $1,000 an ounce to start wading back into the market," Pinto said.

Related Articles

This article has 10 comments:

  •  
    Aug 15 09:02 AM
    Although the premise for an ETF like CUT makes sense, the makeup of the index does not and I don't see much correlation between timber and that of CUT. CUT seems to follow the market as it consists of mainly paper product co.s. Put a stock like PCL next to CUT and see difference. I wish there were a better way the average investor to invest in timber.
    Reply
  •  
    Aug 15 09:58 AM
    Inflation and interest rates rise together. Let's say they both go up 1%. The market value of your TIP will drop by its duration, ie., 6%. Another 1% increase in CPI and your investment drops another 6%. Am I wrong about this? That does not seem like protection to me.
    Reply
  •  
    Aug 15 10:16 AM
    Timber:
    Housing will remain overbuilt for years. Paper consumption is declining thanks to technology. Timber prices could fall.

    Energy:
    Energy use declines with the enonomy, particularly in the developing countries that supposedly led this run-up. High prices are the cure for high prices. The more fuel-efficient cars and HVAC systems being bought now will be with us for 10-15 years, just like in the 80's. 6-7 year old SUV's have already become spare cars.

    Metals/Commodities:
    Still at historic highs, so it would take a lot of guts to buy here. The time to buy was a decade ago. Metals and materials use will decline with the economy. How many people will continue to buy gold jewelry if their economy declines? How many fewer computer chips will be made? How much less coal will we have to burn when all these marginal businesses go under and turn out the lights? What happens to agriculture if ethanol subsidies or tariffs are reduced?

    I would suggest buying defense industry stocks and forex ETF's such as FXA, FXE, FXK, and FXS.
    Reply
  •  
    Aug 15 11:46 AM
    since the gov. figures are a joke how will tips help? the real app. inflation rate of the 5 basic daily needs is 15-16%.my div. yield is app. 9-10% & thats good but not good enough.tips are a joke. another scam among many.
    Reply
  •  
    Aug 15 12:04 PM
    The biggest problem with TIPS isn't the CPI. Don't get me wrong, the CPI is completely broken and useless as a measure of the cost of living. But some goods and services are actually tied to the CPI; for example, some cities with rent control limit rent increases to the CPI increase or some fraction thereof. As an asset to match against that sort of liability, then, TIPS would seem ideal.

    Unfortunately, the real crime of inflationary policy becomes apparent when one contemplates such a move. The nominal increase in principal value of a TIPS - the portion that the government agrees does not represent any real gain whatsoever - is taxed at the time it accrues! This is not only unconscionable, it also renders these instruments essentially useless for producing income to be matched with CPI-indexed liabilities.

    Let us take the example of a retiree in a 30% combined tax bracket living in a rent-controlled apartment with a current rent of $1000 a month and a control indexed to the CPI. Let us assume for the moment that the market's expectations are correct and a 233bp breakeven turns out to be in line with future reported CPI and that one intends holding to maturity. One would need to buy $723000 worth of TIPS to generate enough income to cover the rent. Already we have a problem - if one has that much cash, a better way to guarantee a residence would be to buy the place. But it gets worse - the tax bill on the interest income is $3600 - and the tax bill on the accretion is another $5054! The net after-tax income on this investment is a mere $3347, a far cry from the $12000 we need. In reality, we will need $2.592m in TIPS to provide a CPI-protected income stream of $1000 a month: a real after-tax return of 0.46%.

    Even in situations that would seem to favour TIPS, they simply don't work. To make matters worse, TIPS, like all Treasuries, are absurdly overpriced today. Those looking for income with protection from rising prices are advised to consider large-cap telecom equity, "too big to fail" bank preferreds, gold (cheap at any price, insanely cheap at $788) or dividend-paying miners, and oil&gas trusts. The risk-averse might consider this mix as 20-40% of a portfolio with the balance in CDs. It's far from perfect, but almost anything is better than TIPS.
    Reply
  •  
    Aug 15 07:30 PM
    Puttster: TIPS provides inflation protection for the real income from the bond, and that's it. The regular bond get hit too from a rise in interest rates without the offset TIPS have.

    Sure there may be some better investments, but if you want an extremely conservative one, they beat comparable Treasuries in this regard and have done a lot better than the S&P 500 the past year.
    Reply
  •  
    Aug 16 11:27 AM
    Buying UST MO RAI DOW KFT JNJ MSFT KO with Pes under 16 will OUTPERFORM these insturments over time
    Reply
  •  
    Aug 16 01:49 PM
    Why Make it so hard. I think SLV and GLD are likely to do better than tips, (and there is no way to avoid inflation) - for a while - and then the turn is toward deflation when housing hits jobs and jobs hit retail and manufacturing and P/Es fall like rain and serious recession or worse starts. When that happens treasuries or high yields will be come invaluable so long as they are paid in cash. Other than that just hold cash in some currency you trust. Worry about that last right now I am not sure I trust any fiat currency. The decoupling device failed you see.
    Reply
  •  
    Aug 28 04:00 AM
    You forgot to mention a fairly new ETF called the SPDR DB International Government Inflation-Protected Bond fund ticker WIP. It invests exclusively in non-dollar inflation-indexed bonds. It was launched in April 2008. It's both a play on a weakening dollar and on protecting against inflation.
    Reply
  •  
    Sep 03 02:49 PM
    However poor a measure of inflation CPI may be, the so-called advantage of stocks, the equity premium over safe bonds, is also measured against CPI. A 10 year TIPS guarantees 1.7% real return over the next decade. Will you be able to beat that with stocks over the next 10 years? If history is a guide, the answer is yes. The equity premium is estimated to be a 5 percent real return over safe bonds, yielding a predicted 6.7% real return The only question is whether history will repeat itself. We all know the answer to that. Don't we?
    Reply
More Comments on TIP »
More by Index Universe
Investment Resources
Money Managment
Research
Seeking Alpha provides these ads as a service to its leading contributors
Articles on related themes
Economy
Asset Allocation with ETFs
Closed-End Funds
Commodity ETFs