For clients who fear inflation coming down the pike, I often get questions about TIPS (Treasury Inflation Protected Securities).
First a disclaimer: I do not believe that inflation will be a problem for years to come. There is too much capacity anywhere you look to create inflationary pressures.
I understand that Fed's current policy of printing large sums of money and throwing it into the market is scary, and could be inflationary, but I think that when you have too much supply and very tepid demand it is hard to stoke the inflationary fires.
Still, I could be wrong.
And so when clients ask about TIPS, here's what I say:
Inflation-indexed securities have been an imperfect inflation hedging mechanism for investors in this country as well as abroad for many years. Britain, for example, introduced inflation-indexed bonds in the early 1970's but the value of the bonds did not protect investors. The problem is the calculation of the inflation rate itself.
In this country, for example, economists usually talk about the consumer price index (CPI). The problems with CPI are numerous, however, ranging from geographical differences in prices to the "substitution" effect. In addition, roughly 40% of the CPI calculation is something called "homeowners equivalent rent", which is the government's attempt to measure the cost of housing.
For example, let's say you have two people: Mary, who lives in San Francisco, and John, who lives in St. Louis.
Housing in San Francisco, according to the Case-Shiller indexes, has been remarkably resilient. Prices on houses in San Francisco are up approximately +10% year-over-year, making it one of the few places in the country that has seen housing appreciation.
Other living expenses in San Francisco are high as well. For example, I heard on the radio this morning that San Francisco has the highest cost of gasoline in the country, with a gallon of unleaded going for $3.15.
John, on the other hand, has seen the value of his property decline year-over-year. And unleaded gasoline only cost $2.55 a gallon in St. Louis, which according to the radio this AM makes it the cheapest place in the country to buy gas.
So whose experience is the correct one to measure inflation?
Then there's adjustment mechanism. The government takes the trailing 12 month CPI at the end of each year and adjusts the principal balance of the TIPS. For example, if the last 12 month inflation rate is 3%, the principal balance of a note goes from, say, $1,000 to $1,003. This process is then repeated until the TIPS mature.
(This principal adjustment, by the way, is taxable if the bond is held in a taxable account, creating a "phantom income" problem for some).
I could go on, but let me add a couple of more points.
Historically, money market rates have tracked inflation pretty closely. Put another way, going back several decades, the "real return" (i.e. inflation-adjusted) of money market funds has been zero. This is seems logical: capital markets don't reward riskless investments, but they don't historically penalize them either.
If you really think that inflation is just around the corner, just leave your money in cash, and rates will begin to rise if inflation picks up.
Finally, I should note that bond traders have another interpretation of "TIPS": "Totally Illiquid Pieces of Sh*t". While off-color, the traders are reflecting the fact that TIPS tend to be one of the lesser liquid bonds that the Treasury issues, and often the bids are poor when investors attempt to sell prior to maturity.
So, if you're looking for an investment that trades poorly, offers mediocre protection against inflation, and wants you to pay a yearly fee to the government besides (which is what a negative yield means), the Treasury just sold $10 billion today, so there should be some trading in the secondary market.
But I wouldn't recommend them.
Here's the details from today's New York Times:
Inflation-protected securities sold at negative yields for the first time ever on Monday as traders anticipate that the Federal Reserve will start a new round of asset purchases.
Analysts said that asset purchases by the Fed would lead to a higher inflation rate and a positive return on the bonds.
The $10 billion auction of the five-year bonds sold at a negative yield of 0.550 percent, according to the Treasury Department. The results of the auction of the securities, known as TIPS, came as indexes on Wall Street edged higher, buoyed by recent strong corporate earnings and a rise in housing sales. The previous lowest yield for the TIPS was in the auction on April 26, when the yield was 0.550 percent.
Treasury Sells Bonds With a Negative Yield - NYTimes.com