Favorites Finance

TIPS Revisited

TIPS provide protection from inflation, but they are not perfect

One year ago, I wrote an article that discussed Treasury Inflation-Protected Securities (TIPS). TIPS are important because they provide the best protection against inflation among the universe of fixed-income securities.

TIPS, however, are not perfect. In fact, several prominent investment professionals have publicly addressed TIPS-related issues over the past year. In this article, I’ll discuss some of these issues and relate them to the concerns of sensible long-term investors.

TIPS are fixed-income securities whose face values adjust to keep pace with the Consumer Price Index (CPI), a common inflation indicator. Investors earn a fixed rate of interest on the inflation-adjusted face values. The amount of inflation compensation TIPS investors receive, therefore, directly depends on the CPI.

It’s difficult to measure such a broad economic phenomenon as inflation. The government’s methods are not perfect. To calculate the CPI, the government monitors the prices of a basket of goods and makes certain adjustments, including “hedonic” adjustments and substitution adjustments.

The government may make a “hedonic” adjustment when, for example, the price of a digital camera increases because of higher quality and/or better features. In this case, the price of the camera may not have increased for the purpose of calculating the CPI.

The government also may make substitution adjustments when they assume that consumers will substitute one good for another based on the price of one of the goods. For example, if the price of butter rises, consumers may instead use margarine. The higher price of butter, therefore, would not necessarily increase the CPI because the government assumes consumers will substitute margarine for butter.

“Talk about a con job!” Bill Gross, PIMCO’s chief investment officer, wrote when discussing these CPI adjustments in his October 2004 Investment Outlook letter.

Mr. Gross added: “[These CPI adjustments] disserve buyers and holders of TIPS, which adjust inadequately to a faulty and near fraudulently calculated CPI that could total billions of dollars per year for TIPS holders.”

The government also calculates the “housing” component of the CPI nonsensically. Instead of measuring changes in house prices, the government measures changes to the rental income homeowners could receive for renting their homes (regardless of whether homeowners are actually renting their homes).

In addition to subjecting investors to a new sort of risk—I’ll call it “CPI calculation risk”—TIPS also may not yield a competitive real rate. In other words, TIPS are not immune from becoming overvalued (or undervalued) just because they adjust for inflation.

Assume, for instance, that a 10-year TIPS note has a yield-to-maturity of two percent, and a 10-year traditional Treasury note has a yield-to-maturity of six percent. In this example, investors expect that inflation will be about four percent over the next ten years. If inflation is less than four percent, the traditional Treasury note would outperform the TIPS note because the TIPS note’s overvalued purchase price would’ve reflected a higher inflation expectation.

Unfortunately, inflation predictions are purely speculative. The CPI only tells investors what inflation was, not what it will be; therefore, determining whether or not TIPS are overvalued or undervalued is more art than science. Consequently, long-term investors should consider TIPS as tools for neutralizing inflation rather than as speculative instruments.

Long-term investors will find that TIPS have an inherent advantage over traditional bonds when it comes to keeping up with inflation. An investor can hold a 20-year TIPS bond and reasonably expect that its return will, at least, equal inflation. An investor cannot safely assume that holding a traditional 20-year Treasury bond will return the inflation rate.

Preservation of purchasing power is the first goal of saving for retirement. Inflation erodes purchasing power. If inflation was, hypothetically, just three percent every year for the next twenty years, an investor’s $250,000 retirement savings would be worth only $138,418.94 due to inflation.

TIPS automatically neutralize that inflation risk. Despite the difficulties associated with measuring inflation and, thus, adjusting TIPS’s face values, they should still be a part of an investor’s fixed-income portfolio.

Note: A version of this article appeared in the March 23, 2005 edition of The Daily Record, a law and business newspaper published in Rochester, New York.