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10-Year TIPS: An Investor's Benchmark

by: James Picerno September 03, 2008 | about stocks: IPE / TIP    
James Picerno

James Picerno

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Every investor needs a benchmark. Picking a relevant one is a challenge, in part because the menu is crowded. The good news is that there's a great starting place for everyone: the yield on the 10-year inflation-indexed Treasury Note, a.k.a., the 10-year TIPS.

As guaranteed payouts on Mother Earth go, this one's about as solid as they come. Not only can you sleep easy knowing that your principal will be returned, the payout in the years ahead will be immune from inflation. Yes, one can argue that the underlying inflation yardstick--the consumer price index--is flawed, but we'll leave that glitch aside for the moment.

Accepting the 10-year TIPS at face value gives us a robust benchmark for comparing and contrasting our investment strategies. It is, in short, the true risk-free benchmark for investors considering the rainbow of risks in the world to embrace or avoid. Yes, we could quibble and cite the 5-year or 20-year TIPS. But we'll split the difference and use the 10-year span, in part because much of bond investing revolves around decade-long maturities as benchmarks.

As of last night, a 10-year TIPS yields 1.69%. The question before the house: can you beat it? That is, will your investment strategy generate more than a 1.69% return--after inflation--when you crunch the numbers on September 3, 2018?

No doubt some, and quite probably many investors will answer in the affirmative. But the task ahead is tougher than it appears. Why? Several reasons, starting with the fact that buying and holding a 10-year TIPS is a strategy with no moving parts. As such, there's no chance for error in executing the strategy and grabbing the yield as stated. But as history suggests, a fair share of investors who try to excel at the money game will end up being stumbling, perhaps dramatically.

Nonetheless, many will claim that besting the 10-year TIPS yield presents a minimal challenge. Perhaps, although beating this benchmark may not be the cakewalk it appears to be. Consider the outlook five years ago. The 10-year TIPS yield was 2.43% at the close of trading on September 2, 2003. Did that yield represent a muscular yardstick? It was easy to think not. Indeed, a conventional 10-year Treasury yield at the time was 4.61%, or nearly twice the TIPS yield. Keep in mind that the inflation outlook at the time was fairly modest. CPI was up just 2.2% for the year through August 2003, and expectations for anything materially higher were a rarity.

But five years later, the conventional 10-year's yield-inferred return doesn't look encouraging. CPI's rise over the past five years through July 2008 has averaged 3.65% a year. Deducting that inflation rate from the 10-year's 4.61% yield of five years ago leaves a real yield of just under 1% these days. In short, the 2.43% real yield of TIPS now looks far more enticing than many thought back in 2003.

Clearly, one's inflation expectations are critical for weighing the investment options of the moment. The exception is when choosing TIPS. Inflation may soar into the stratosphere, or tumble into deflation, but when you buy an inflation-indexed Treasury you lock in the current real yield. Come hell or high water, you'll receive that real yield.

That leaves the question of whether the 1.69% real yield that currently profiles the 10-year TIPS will suffice. It certainly looks low relative to recent history. Perhaps that inspires you to think that equities, commodities, REITs or other investments will fare better over the next 10 years. Or, maybe a diversified portfolio of several asset classes is the prudent choice, a strategy your editor tends to favor for the long run.

In truth, no one knows the answer. But our analysis must start somewhere, and the 10-year TIPS is arguably the first step for assessing what's available for everyone, no questions asked. In a world of risks, unknown and known, the first investment decision is uncomplicated: should we accept or reject the government's 10-year real yield? Question two, by contrast, is infinitely more complex.

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This article has 23 comments:

  •  
    Sep 03 02:55 PM
    come on! If you dont eat ,dont drive, and dont have medical insurance or expense, it will still cost you more than 1.7 % to live over the next ten years. I budgeted 10 % with the above expenses and since 1999 I'm close to being right on. my health insurance alone has gone from $3500 a year to $12000 a year. A good retirement is a second job!
    Reply
  •  
    Sep 03 03:02 PM
    (1) it is possible to lose a LOT of money on a 10 year tip bond if you don't buy a new issue, or if you buy one that has been marked up to reflect past inflation. In other words, if you buy a 20 year tip bond with only 10 years left, that has already been marked up by 30% due to past inflation, and then we experience deflation going forward, then you will lose money. You will actually lose principal and be returned less than you paid. The same thing goes, to a lesser effect, if you buy the ishare instead of actually buying a tip bond.

    (2) That being said, Since 1970 we've experienced oil shocks, minor wars, political scandals, terrorist attacks, all sorts of good & bad things, etc., etc. Since then CPI has NEVER been negative. Only 5 times has it gone below 2%. Comparing the TIP yield to a yield of a regular treasury, or cash, is the reason they are a compelling buy. It's heads I win, tails I don't lose (if you buy the right tip).
    Reply
  •  
    Sep 03 04:03 PM
    I decided to diversify a portion of my IRA into TIPS last year. I purchased the SPDR TIP ETF (symbol IPE) in early October 2007.

    There's an old saying that "I'd rather be lucky than smart". I guess I'll have to agree in this case. As you can see from the chart posted in this article TIPS have been a FANTASTIC investment over the past 12 months, especially considering that almost everything else I hold has been going down (except commodities).
    Reply
  •  
    Sep 03 04:16 PM
    Buy PM todyt at 54.05 you will get over a 4% dividend ,it just got raised 17% and you have no chance of EVERY country facing litigation. In 10 years you will be SOFAR ahead counting reinvested divdends it will not be funny
    Reply
  •  
    Sep 03 04:34 PM
    'coherent commentary',

    If what you were saying were true, some TIPS would have a negative yield to maturity. Bonds aren't 'marked up', and even if you buy a bond the day it is issued directly from a primary dealer, you may still be buying it above par, which, ignoring coupons, means you wouldn't get your principal back. Ten-year zero coupon TIPS issued five years ago are indistinguishable from five-year zero coupon TIPS issued yesterday.

    You can learn more about TIPS and bonds in general at www.investopedia.com/t...
    Reply
  •  
    Sep 03 09:57 PM
    I guess one issue (one that you brought up) really can't be put aside. Until the Fed starts to use the Volker method of calculating Inflation, these things will never hit true paydirt. That being said, they still are a good investment.....
    Reply
  •  
    Sep 03 11:50 PM
    Don't forget to pay ordinary income tax on the accretion! That's right; the "gain" that even the government openly admits is not a gain at all is subject to taxation at the max rate.

    TIPS are a horrible investment. They pay a miniscule return on top of a mind-bogglingly defective index controlled by their issuer, and when taxes are factored in you're lucky if you have a paper profit at all, much less a real profit. With debasement running 7-12%, the CPI at 5%, and taxes at 35%, you'll be lucky to lose only 30% of your purchasing power over your 10-year holding period.
    Reply
  •  
    Sep 04 12:35 AM
    Owen, you are wrong. I just bought a ten year tip trading at 97. If there is MASSIVE deflation, I will receive 100 when it matures. I could have bought a 10 year tip (that used to be a 20 year tip) for 130. If there is massive deflation I might only get 100 back at maturity.

    Bearfund, tips are great in a retirement account where taxes aren't an issue. If you modeled your theoretical return on tips over the last 10, 20, 30 etc. years (had they existed), they would've been an excellent addition to a portfolio... completely replacing cash and lowering overall volatility.
    Reply
  •  
    Sep 04 02:35 AM
    I think TIPS are a terrible investment. From what I've read, the inflation rate, published by the Federal government is not accurate. It understates inflation. So, buying a bond, based on those numbers, insures that the buyer will lose money over time. Ten years is too long to tie money up at artificially low inflation rate increases.

    Ok, some of you will claim we are entering a period of "deflation." Well, I don't like Bernanke any more than anyone else. But, what he said, before he was appointed to the Chairmanship of the Federal Reserve, still holds true. IT IS IMPOSSIBLE TO HAVE DEFLATION in a economy based upon fiat money, because, in a pinch, the government can simply print money and drop it from helicopters -- which it most certainly will. Actually, with all the M3 growth we've seen over the past year, they not too far away from the helicopter drops right now!
    Reply
  •  
    Sep 04 05:15 AM
    every investor's benchmark should be M3 growth, because this is the mass of credit that inflates the economy.
    Reply
  •  
    Sep 04 08:48 AM
    'coherent commentary',

    The two TIPS you describe have a different price because they carry a different coupon, not because of when they were issued. TIPS issued ten years ago had a much higher coupon rate, and so now, when yields are lower, it carries a higher price. The yield to maturity of both bonds you describe is identical. With the older one you get a larger portion of your investment in the form of semiannual coupons, while with the newer you get more at maturity and lower coupons. You seem to have a fundamental misunderstanding of how bonds work; it may be a good idea to educate yourself on that before investing in them.

    Also, the singular of TIPS is also TIPS. The 'S' stands for Securities, not to pluralize 'TIP'.
    Reply
  •  
    Sep 04 09:25 AM
    coherent, I'd agree that in a Roth TIPS would be slightly more attractive, but they'd offer no advantage in a regular IRA. Still, the worst problem with these instruments is that they are based on an index controlled by their issuer. It's as if you took a loan from a bank and each month when it's time to make a payment the bank asks you "So, Mr. Commentary, what interest rate would you like to pay this month?" - and whatever rate you name is the rate you pay. Sweet deal for you. For the bank, not so much.
    Reply
  •  
    Sep 04 09:26 AM
    Owen, ok you got me on the pluralization. Thanks for pointing that out. But you might want to go ahead and correct the people who write the U.S. Treasury website, because they refer to it the same way I did. Oh, and while you're over there arguing with those folks about how they're spelling the bonds they issue, have a gander at the way tips bonds work. I'm not going to argue with you until you read it but it says that the principal is adjusted up or down to reflect inflation or deflation. At the maturity of a TIPS, you receive the adjusted principal or the original principal, whichever is greater. So, If you buy one in the secondary market that has been adjusted up over the last few years, you stand the (slim) chance that it gets adjusted down over the next few years and in that case you could lose your principal.
    Reply
  •  
    Sep 04 09:32 AM
    bearfund, I too have a problem with that index. It totally missed the run up in housing (a huge consumer expense) and now that housing is falling off the politicians are calling that a deflationary event.

    However, I became more comfortable with the index when I looked at the actual index data for the last 30+ years and I looked at how it's calculated. The other aspect that gave me a little faith is that recently it has been coming in fairly high (5% up in 1 month) so it appears it's not totally corrupt. All that being said, inflation is a personal issue that is impossible for 1 governement number to try to hit. It is what it is, and I realize it is a speculation but the academics who put the numbers together (BLS) are not the same guys who are accountable for money supply (the Fed), there are political forces that influence both, but I don't think there is a conspiracy. I'm not betting the farm on it, either way.
    Reply
  •  
    Sep 04 10:53 AM
    I have to support bearfund on this issue. Until earlier this year, I had a substantial proportion of our savings in TIPS, When I look at the actual cost of living, I see costs rising much faster and farther than the official government statistics. Using theoretical improvements in certain manufactured goods, as BLS does, suggests that the cost of living is being manipulated. I no longer trust the government. The government is in the service of the Wall Street Thugs
    Reply
  •  
    Sep 04 10:57 AM
    Philman wrote: "Ok, some of you will claim we are entering a period of "deflation." Well, I don't like Bernanke any more than anyone else. But, what he said, before he was appointed to the Chairmanship of the Federal Reserve, still holds true. IT IS IMPOSSIBLE TO HAVE DEFLATION in a economy based upon fiat money, because, in a pinch, the government can simply print money and drop it from helicopters -- which it most certainly will. Actually, with all the M3 growth we've seen over the past year, they not too far away from the helicopter drops right now!"

    There can always be periods of deflation in some assets. Current examples are houses and stocks over the past year or so. Maybe we are into a similar period for commodities (and maybe we're just having a short-lived correction).

    There are also examples of much longer duration. There are places in this country were (former) agricultural land sells for less today than it did 100-150 years ago. There was a 20+ year period starting in late 1929 when stocks were deflating much of the time. In the same period many other assets, including real estate, deflated. We had some vestiges of fiat currency during parts of this history, although not to the extreme we have had since 1972.



    Reply
  •  
    Sep 04 01:48 PM
    you cant believe govt. #s.so this issue is critical & cant be ignored.the inflation rate of the 5 basic daily needs is app.15-16%.how are tips going to help?
    Reply
  •  
    Sep 04 04:22 PM
    'notsosmart',

    Where exactly did you pull your 15-16% number from? If inflation was really a consistent 15% a year, then prices in 1992 would have been exactly one tenth of what they are today. A new 1992 car would have cost $3,500, a suburban home around $30,000, a new PC around $50, and a burger and fries exactly one shiny quarter. What fantasy world do you live on?

    Perhaps you should stick to promoting FRO stock as you always do.
    Reply
  •  
    Sep 04 04:38 PM
    hey owen-i got the #s on inflation off this site. they have nothing to do with a new car. only with the 5 daily basic needs-gas,health,food,... over your head) & utilities.
    Reply
  •  
    Sep 04 04:41 PM
    i have no agenda nor does it matter to me wether anyone buys FRO or not.its the only stock that i owned that paid for itself with div.i dont trade it so the ups & downs mean nothing to me.
    Reply
  •  
    Sep 04 05:07 PM
    And who chose these "basic needs"? The average US family spends over $8,000 a year buying cars, not even counting maintenance and insurance. That's far more than you spend on gas, and often more than you spend on food. But since you don't buy a car every day, it's easy to forget that expense. Same with other big ticket items.

    Gas prices have doubled in the past three years; this corresponds to an annual inflation rate of 26%. Why not use this number? It's easy to play with the numbers and come up with whatever inflation figure you feel like. I don't believe the government numbers reflect the absolute truth, but they're a hell of a lot closer to it than your fictitious 15%.
    Reply
  •  
    Sep 04 07:58 PM
    its not my fictitous #.its the experts like you on these sites.i drive a 17 year old caprice.new car prices dont mean much to me & by the declining sales of cars it may mean less to a lot of people than the 5 daily expenses.its a big difference between 99cent gas & $4 gas.i paid 99cents not too long ago. same car.
    Reply
  •  
    Sep 05 12:44 AM
    actually you can have inflation and deflation at the same time. because of the makeup of the cpi which is used by the government to calculate inflation - it always rises so we will always have inflation. because we always have inflation the gdp numbers will also keep rising, but the assets which comprise a portion of the gdp will fall - just like is happening now. basically your net worth falls while prices go up. it is not deflation as defined by the economic doctors who post on this site - but it is deflation none the less.
    Reply
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