| | | Start Me Up Understanding TIPs
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I have received an increasing number of orders to purchase U.S. government inflation index bonds, more commonly known as TIPs. I have noticed two trends while fielding these calls. First, many clients and some financial advisers are trying to time the market to make a big score when inflation spikes. Secondly, they don't know what makes TIPs tick.
Unlike traditional U.S. treasury notes and government bonds, TIPs have two components which affect their performance. There is the stated maturity which is influenced by Fed interest rate policies on the short end of the curve and inflation on the long end of the curve. However, unlike traditional U.S. treasuries TIPs have inflation indices which adjust up or down with inflation as measured by the CPI Urban Consumer Index Non-seasonally Adjusted (CPURNSA). As the index rises or falls so do TIPs indices. The principal face of a TIP is adjusted using the factor. The amount of accrued interest paid is calculated using the adjusted face.
The fact that it is the principal is adjusted is often overlooked by investors. If one is purchasing 10m TIPs at 101 with an inflation index of 1.02 the principal cost is $10,302 (10m x 101 x 1.02). Forgetting the TIPs index often results in trade errors when TIPs are purchased as bonds may be costlier than they appear when only the quantity and price are considered (don't forget about accrued interest as well). Not accounting for the inflation index can lead to another, potentially more serious, problem.
We know that TIPs indices adjust up when inflation rise, but they also adjust lower when inflation falls. It is possible to lose money on TIPs when inflation falls. Inflation does not have to go negative. It only has to be less positive than when you purchased your TIPs. The good thing about a TIP is that its index cannot be below 1.00 at maturity. However, it could move below 1.00 during its life. This can lead to losses should an investor need to liquidate his or her investment prior to maturity. The knee-jerk response would be to point out that if inflation fell, interest rates would fall and that would support the price of the bond. This is somewhat correct, but the price of a TIP is far more influenced by movements in its inflation index than by interest rates. Not understanding what influences TIP valuations can lead to costly strategic mistakes.
The majority of the calls I receive from financial advisers wishing to purchase TIPs are orders to buy short-term TIPs. Their thinking is that inflation will be very positive in the early stages of the economic recovery as is usually the case. What they fail to recognize is that the belief that inflation will rise in the near term is already baked into short-term TIPs prices resulting in high premiums. They also fail to recognize is that inflation measured by the CPURNSA has been moving higher thereby pushing inflation indices on short-term TIPs higher. It is not uncommon to see two or more point premiums on short-term TIPs and inflation indices significantly above 1.00.The danger here comes from the possibility of moderating inflation.
Many economists are calling for the economy to cool off to a growth rate in the low to mid 2.00% area with below trend job growth. If this forecast plays out owners of short-term TIPs could get clobbered. TIPs coupons are very low. If inflation moderates considerably, falling indices and prices amortizing back to par could result in net losses even if TIPs are held to maturity. Those looking to buy TIPs for real intended use (to hedge a portfolio of bonds) may want to consider 10-year TIPs.
When I suggest 10-year TIPs many FAs ask if I am crazy or how long I have been in the business. They point to the fact that the 10-year portion of the curve is very volatile, experiencing sharp price swings when long-term rates move. Again, these critics are missing the key element within a TIP, the inflation index.
We already discussed how the price of a TIP is more greatly influenced by its inflation index because adjusting for inflation is its true purpose. We also know that long-term rates rise when inflation rises. This can cause the price of the 10-year treasury note to fall, often dramatically. However, at the same time the 10-year treasury note is falling due to rising rates, the 10-year TIP should rise thanks to higher inflation expectations. This is exactly what has happened since March 2009.
What if inflation falls? if that happens all TIPs will lose value, but since the 10-year TIP has longer to go before maturity and that it is unlikely that the U.S. falls into a long-term deflationary trend as Japan did 10-year TIPs will hold their value better than shorter-term TIPs which do not have the time to experience a new inflationary cycle farther down the road.
The best way to buy a TIP as a hedge is to buy whichever TIP has the lowest price AND (more importantly) the lowest inflation index. Such TIPs will experience the same kind of gains as shorter-term TIPS with high indices and high premiums in an inflationary environment, but should be less negatively impacted in a deflationary environment.
What about TIPs funds and ETFs. The are good ways to speculate on TIPs as they are diversified among more than one TIP, but that also means that they probably hold TIPs which can be disadvantaged under short-term deflationary conditions. TIPs were designed as a hedging vehicle and not as a vehicle with which to speculate. Only an actual TIP can be used to hedge a portfolio of bonds.
If you have any further questions regarding TIPs or other bonds feel free to drop me a line.
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