Wednesday, April 27, 2011

TIPS: Great Deal for the Government, Bad for Investors

If you truly are worried about a resurgence of inflation - which Random Glenings is not, but this is a minority view - you might be considering an investment in Treasury Inflation-Protected Securities (TIPS).

Please don't.

Quick background: TIPS offer investors the theoretical ability to hedge assets against inflation. Although the nominal yield on TIPS is lower than traditional US Treasury securities, the principal balance of your investment is adjusted higher each year based on the change in the CPI.

There are numerous problems with TIPS from both a structural and liquidity standpoint, but I won't go into them here.

My most relevant point today is that with all of the current hype about inflationary pressures, investors seem to be willing to pay almost any price for protection.

Thus, at the present time, the nominal yields - that is, the cash flow you the investor will be receiving periodically over the life of your investments - are ridiculously low on TIPS.

For maturities out to six years, for example, nominal yields are negative. Put another way, you are paying the government a fee each year for the supposed inflation protection. Even 10-year TIPS are yielding 0.72%.

Ah, you say, but at least I am protected against inflation.

Well, maybe, but if you just leave your money in a money market fund, or invest in short maturity CD's, you will be better-protected and have considerably more liquidity.

Why is that?

If you look back historically - say, over the last 60 to 70 years - short term interest rates and inflation rates track very closely. In the language of economists, "real" short-term interest rates are 0% over longer periods of time.

This stands to reason, even in today's environment. If the Fed were to witness a resurgence in inflationary pressures, they would most likely ratchet up short term rates fairly quickly.

In other words: Don't buy TIPS. As a fellow citizen of the United States I appreciate your efforts to reduce our government deficit, but there are better ways to contribute.