TIPS for the New Year?

The unprecedented and unconventional easing measures enacted by the central bank of the United States over the past two years to create and support the economic recovery have had little visible effect on price inflation thus far.  The Fed’s preferred inflation measure, Core PCE, which excludes volatile items like food and energy, has not budged and the most popular inflation measure, the Consumer Price Index, which includes such items, has barely risen. 

A majority of economists expect inflation to remain out of sight in the very distant horizon as well.  But, as the Fed continues to keep monetary policy expansionary into 2011, some investors are eagerly watching for a spike in inflation to appear.  It is these investors that are looking for inflation through bifocals not binoculars.  And it is these investors that are positioning their portfolios accordingly.

Treasury Inflation-Protected Securities
One such tool that investors with rising inflation concerns are turning to are Treasury Inflation-Protected Securities, more commonly referred to by the acronym TIPS.  Created in 1997, TIPS have been growing in popularity but account for less than 10 per cent of overall outstanding treasury debt.

Like treasury notes and bonds, TIPS are issued by the US Treasury Department and have a coupon rate that is fixed on issue.  However, the principal that the Treasury Department bases the dollar amount of the coupon payment and the maturity value on is adjusted semi-annually with the Consumer Price Index, making them attractive investments to hedge inflation risk.  If inflation occurs, the interest payment increases, and conversely, if deflation occurs, the interest payment decreases.  At maturity though, investors receive the greater of the adjusted principal and the original principal.  This provision protects against deflation.  

Reading into TIPS
Because TIPS are adjusted for inflation, the coupon rate, determined by auction, is often thought of as a real rate – the rate that the investor earns above the inflation rate. As a result, TIPS typically pay a lower interest rate than conventional treasuries.

Tracking the difference between TIPS yields and similar-termed Treasury Note/Bond yields reveals market expectations for inflation too.  As at time of writing, a 10-year Treasury note was yielding 3.26 per cent and a similar-termed TIPS bond was yielding 0.97 per cent. The difference between the two, 2.29 per cent, is referred to as the TIPS’ break-even spread. It reflects what the market expects inflation to be over the next 10 years. 

As you can see in the attached graph, market inflation expectations have picked up from August and are now generally in line with historical averages.  This recent pickup is largely the result of the lead up to, and the announcement of, the Fed’s second round of quantitative easing, which was formally announced on 3 November.  

Gaining exposure to TIPS
To profit significantly by investing in TIPS, one would need to correctly anticipate changes in inflation before others do.  At the very least though, TIPS can be used to diversify an investment portfolio and can be especially important for retirees that may be sensitive to inflation affecting fixed income streams.

You can buy TIPS either individually or indirectly by investing in a mutual fund or ETF.  (See examples in Table 1).  As with any investment, there are pros and cons to consider.  Please seek the advice of an investment advisor to understand the risks, tax implications and return characteristics of an investment before investing.

The views expressed above are not necessarily those of Butterfield Bank (Cayman) Limited.  Financial statistics sourced from Bloomberg. 

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Stock Watch, with Brad Bishop, Butterfield Bank

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