I’ve been getting lots of questions lately about the merits of owning Treasury Inflation-Protected Securities (TIPS) versus nominal bonds. With that in mind, today I’ll discuss how to determine which is the more appropriate strategy.

To begin, we need to recognize there are two ways one can hold TIPS and nominal bonds: purchase the bonds individually or invest in mutual funds/ETFs. When investing through taxable accounts and IRAs, one can do either. However, in corporate retirement plans, such as a 401(k), one is limited to funds.

5-Year Maturities For Comparison

To keep the analysis simple, and because my firm, Buckingham Strategic Wealth, generally recommends building bond portfolios with an average maturity of about five years, I’ll analyze TIPS and nominal Treasuries with five-year maturities. (The same analysis can be done for other maturities.) As of this writing, Aug, 14, 2018, the five-year TIPS was yielding 0.77% and the five-year nominal Treasury was yielding 2.76%. Thus, the breakeven inflation rate was 1.99%. That doesn’t mean, however, the market is estimating future inflation of 1.99%.

There are two reasons why you cannot make this assumption about inflation. The first is that nominal Treasury bonds are the most liquid market in the world. While TIPS are relatively liquid securities, and also carry the full faith and credit of the U.S. government, they are not as liquid as nominal bonds. Investors in nominal Treasuries pay a premium (in the form of a lower yield) to own them. The second is that the yield on nominal Treasuries has three, not two, components: the real yield, the expected rate of inflation and a risk premium for unexpected inflation. TIPS yields are determined only by the real yield.

TIPS-To-Nominal-Bond Spread

Observe that the liquidity premium (which depresses yields) and the risk premium for unexpected inflation (which increases yields) work in opposite directions and may cancel each other out. If that is the case, then the TIPS-to-nominal-bond spread is a good indicator of the market’s aggregate view of expected inflation.

To obtain an estimate of expected inflation, we might use the Federal Reserve Bank of Philadelphia’s Survey of Professional Forecasters. This survey is the oldest quarterly survey of macroeconomic forecasts in the U.S. It began in 1968 and was first conducted by the American Statistical Association and the National Bureau of Economic Research. The Federal Reserve Bank of Philadelphia took over the survey in 1990. Those making forecasts include more than 50 economists from many of the leading financial and research institutions in the country. Their views help shape opinions about expectations for inflation.

2.2% Inflation Forecasts

The survey’s third-quarter 2018 estimate for inflation over the next 10 years is 2.2%, which is slightly higher than the breakeven inflation rate of 2.0% obtained by comparing the yields on TIPS and nominal Treasuries. Thus, ignoring the liquidity premium, instead of having to pay a premium to hedge the risk of unexpected inflation, investors are actually being paid a slight premium (about 0.2%).

An alternative method is to use the five-year inflation swap. The inflation swap’s current market price is about 2.4%. Using 2.4% as the inflation estimate provides an expected return on TIPS of 3.17%, or 0.41% more than on the nominal Treasury. The negative premium of 0.41% makes TIPS the obvious choice.

The academic research, including the 2004 study “Asset Allocation with Inflation-Protected Bonds,” the 2006 study “Diversification Benefits of Treasury Inflation Protected Securities: An Empirical Puzzle,” and the 2016 study “Residual Inflation Risk,” makes the case that because of their diversification benefits, unless the risk premium for unexpected inflation is large, investors should strongly prefer TIPS. This is especially true for investors vulnerable to inflation (such as retirees living on a fixed income).

Nominal Bond Premium Factor

The only question remaining appears to be how large a premium is required before investors might prefer nominal bonds. In fact, Philipp Illeditsch, author of the study “Residual Inflation Risk,” concluded that “investors should hold a zero-investment portfolio of nominal bonds.”

In my opinion, that’s too extreme a statement, especially for investors who have more ability to bear the risk of unexpected inflation. For example, for investors still in the workforce, real wages tend to keep up with inflation.

S.P. Kothari and Jay Shanken, authors of the aforementioned “Asset Allocation with Inflation-Protected Bonds,” looked at this issue too, specifically in terms of five-year maturities. They concluded that the preference for inflation-protected securities is so strong that if there is no inflation risk premium, the optimal allocation to them is 80%. Even with an inflation risk premium of 0.50%, the optimal allocation is still 60%.

Using Certificates Of Deposit

The bottom line is this: Given that investors in TIPS are not currently sacrificing any expected return, they should greatly prefer five-year TIPS to five-year nominal bonds.

Now let’s turn to a look at the issue when the investor has the ability to buy individual bonds. Because neither bond investment incurs any credit risk, there is no need to diversify risk. Thus, the main benefit of a mutual fund is no longer relevant.

As long as investors are willing to sacrifice the conveniences of a fund (such as the ability to automatically reinvest interest), they can buy individual CDs [certificates of deposit] instead of a Treasury bond or a Treasury bond fund. FDIC-insured CDs typically carry significantly higher yields than Treasuries of the same maturity—which is why my firm generally buys them instead of nominal Treasuries when building laddered portfolios.

Doing The Math

As I write this, the yield on a five-year CD was 3.4%. With the five-year TIPS yielding 0.77%, the breakeven inflation rate becomes 2.63%.

Subtracting from that figure the 2.2% estimated rate of inflation from the Federal Reserve Bank of Philadelphia’s survey of forecasters, we arrive at a premium of about 0.4%.

For investors less susceptible to risks associated with unexpected inflation, a premium of 0.4% a year certainly is worth considering, especially because the maturity in this case is not very long (the risk of unexpected inflation rises as maturity increases).

With a premium of this size, investors who can accept the risk of unexpected inflation should at least think about allocating some significant portion of their fixed-income portfolio to nominal CDs. On other hand, if we use the 2.4% inflation estimate provided by the swaps market, we have a premium of only about 0.2%. At that level, TIPS likely should be the choice for all but the most aggressive investors able to accept the risk of unexpected inflation.

Misconceptions About TIPS

Before closing, I’ll take the opportunity to dispel a few misconceptions I hear about TIPS.

One common objection I hear to buying TIPS is that a good way to mitigate inflation risk is to use short-term bonds. Unfortunately, this is true only relative to longer-term bonds. Short-term bonds don’t hedge inflation risk as well as TIPS, and the comparison is not even close. The reason is that when inflation rises, the yields on short-term bonds do not immediately respond to the change in expectations.

Consider the following example. For the period 1933 through 1951, one-month Treasury bills produced negative real returns in all but three of those 19 years and an annualized real return of -3.2%. Beginning in 2002, we have seen a repeat performance, with one-month, three-month and one-year Treasuries producing negative real returns in all but three (2006-2008) of the following 16 years.

The annualized real returns over that 16-year period for one-month, three-month and one-year Treasuries were -0.9%, -0.9% and -0.4%. And that was with a CPI of just 2.1%.

Do Rates Need To Rise For TIPS?

Another common objection I hear to buying TIPS involves the expectation that real rates must rise. Thus, an investment in TIPS will suffer. First, investors, including the once-acclaimed “Bond King” Bill Gross, have been forecasting rising rates for quite a while, and they have been dead wrong. That forecast cost them dearly, as they lost an opportunity to earn the term premium and rates first fell further.

In addition, they have remained at historically low levels for far longer than anyone had expected. However, the issue is basically irrelevant, because if you are confident that real rates are going to rise, you can simply buy short-term TIPS and avoid, or minimize, the term risk.

There are now even short-term TIPS ETFs, such as the PIMCO 1-5 Year US TIPS Index ETF (STPZ), with an average maturity of about just three years, and the Vanguard Short-Term Inflation-Protected Securities ETF (VTIP), with an average maturity of about just 2 1/2 years, available for investors who don’t wish to buy individual securities (which can be purchased for any maturity).

Another important point to consider is that if the market also expects real rates to rise, that expectation will already be reflected in the yield curve. Therefore, staying short only helps if rates rise more than is already anticipated by the market.

Not understanding this relationship is a common and costly mistake made by investors and advisors alike—along with the error of thinking they can forecast rates better than the market.

This commentary originally appeared August 24 on ETF.com

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