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A Tip About TIPS

Jim Prevor’s Perishable Pundit, February 22, 2008

The term TIPS refers to Treasury-Inflation Protected Securities, which are basically Treasury bonds with a special characteristic: The principal amount of the bond will fluctuate with the consumer price index.

And the agreed interest is paid on the adjusted principal amount.

Now there are some quirky things about these bonds. You prefer to own them in a non-taxable account so you don’t pay taxes on interest payments that just compensate for inflation.

Many people find them complex — although they really are not — and so prefer to own them in funds in which management fees reduce income further.

What is interesting about this article is that the author, Brett Arends, ridicules them as an investment in the current interest rate environment. Here is how he puts it:

In theory, TIPS are an excellent idea. Like all bonds issued by Uncle Sam, they are safe from default. But unlike other Treasurys, they are also supposed to be safe against rising prices as well. They offer a certain guaranteed “real” yield on top of the official consumer-price index. So if inflation rises, the yield rises to match.

The problem? The guarantee that can make these bonds a fortress for your money can also make them a prison. This “real,” or after-inflation, yield is locked in when you buy the bond.

And right now, those real yields are terrible. They recently touched record lows.

The real return on the 10-year TIPS is just 1.56%, according to the Treasury’s latest data. Recently, it sank as low as 1.31%.

For the seven-year bond it’s just 1.23%, and for the five-year, a crazy 0.78%.

Early last fall, long TIPS guaranteed a respectable 2.3% plus inflation. At the time, I wrote that they appeared to be a much better bet than regular long-term bonds. And so it has proven.

But today they look abysmal.

The columnist goes on to call the investment absurd:

As a general rule of thumb, TIPS are usually worth looking at only when the real yield on the 10-year rises well above 2%.

This column doesn’t try to predict short-term market movements. The fact that Wall Street may be doing something really foolish today doesn’t mean it won’t do something even more foolish tomorrow.

So for all I know, TIPS could soar still further in the weeks ahead until they actually guarantee a negative real yield for everybody.

But that doesn’t mean you have to join in. As a long-term investment for serious individuals, TIPS right now look absurd.

We think that Mr. Arends is missing the point entirely. The fact that the market is driving the yields so low on inflation-protected bonds is a clear indication that the market — the collective wisdom of people investing money — is expecting very high inflation.

The Federal Reserve, which is kept semi-insulated from the political process specifically so it can resist political demands, has decided its purpose is not to ensure that the dollar remains a storehouse of value but, rather, that its purpose is preventing a recession.

Congress and the White House can pass all the stimulus programs they choose but, in and of themselves, tax rebates and government expenditures can be only modestly stimulating. After all, the money has to come from somewhere, so if the government is taxing or borrowing the money, that money is not available to be spent either directly by the person or company being taxed or, indirectly, by the financial institution that would be holding the money and lending it out for investment.

So the most you can argue is that the person who will receive a rebate — presumably a poorer person — will spend the money faster than the person who originally had it.

The stimulative effect will actually come from an increase in the money supply and that is highly likely to be inflationary. As Milton Friedman and Anna J. Schwartz explained in their epochal work, A Monetary History of the United States, 1867-1960 “Inflation is always and everywhere a monetary phenomenon.”

It seems from the behavior of the government that the Congress, the White House and the Federal Reserve are all more concerned with “helping” over-leveraged financial institutions and individuals than in ensuring that the dollar is a store of value.

How do you help somebody who is over-leveraged on his house? You inflate the currency so that the value of the property will go up in nominal dollars while the cost of that person’s debt will stay fixed.

Today because of adjustable rate mortgages, it may not work as well since the markets will eventually catch onto what is happening and interest rates will zoom.

Mr. Arends makes a big deal of saying that “This column doesn’t try to predict short-term market movements.” But for his argument to make any sense, you would have to say he is arguing that inflation rates will be very low.

After all, that “absurd” return he alludes to would look great if inflation hits double digits again.

Forewarned is forearmed.

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