Why TIPS might be a smart place to park some money right now

Inflation is running at 8% or higher, depending on how you count it (and who’s counting). The Federal Reserve is clearly panicking. And the markets are clearly panicking too.

So at this point, Uncle Sam would like to offer you a bet.

How would you like to wager your hard-earned retirement savings that inflation is going to collapse in very short order, and collapse so far, so fast that over the next five years the average will be less than 2.4%?

Read: Market Snapshot

Oh, and to make the bet even more interesting, here are some additional terms: If you win the bet, and average inflation comes in below 2.4% between now and 2027, you will make a very small profit—but if you lose the bet you could lose, and lose big.

How does that sound?

Tempted?

If this sounds completely nuts to you, you are not alone. It sounds pretty nutty to me too. But here’s the sting in the tail: You may already be making this bet, without even knowing it. Actually, the more cautious and risk-averse you are, the likelier you are to be taking this bet.

Yikes!

I am talking about investments in U.S. Treasury bonds.

With inflation nudging toward double digits, 5 year Treasury bonds
FVX,
+1.01%

are paying 4% interest and 10 year Treasurys
TNX,
+2.37%

3.7%. The longest-dated bond, the 30 year, is paying 3.6% interest.

These may or may not prove to be successful bets, depending on what happens next with inflation and the economy. Everything that needs to be said about predictions was made by Casey Stengel: “Never make predictions, especially about the future.”

But in this particular instance we have an extraordinary puzzle: While regular Treasury bonds offer the interest rates just mentioned, a parallel set of Treasury bonds offer another set of interest rates with locked in guarantees against persistent inflation. And the prices look…well, weird.

So-called TIPS bonds, which stand for Treasury inflation-protected securities
TIP,
-0.47%
,
are a niche product issued by the U.S. Treasury that come with the same guarantee against default as regular U.S. Treasury bonds, but with prices and interest payments that adjust automatically to account for inflation. (The mechanism is so mind-bogglingly complicated that any attempt to describe the inner workings would confuse more than illuminate. Suffice it to say that if you buy a TIPS bond and hold it to maturity, you’ll get the inflation rate every year plus or minus a determined “real yield,” depending on the price you pay when you buy it).

Right now if you buy 5 year TIPS bonds you can lock in an interest rate of about 1.6% per year plus inflation. If inflation averages 0% over the next 5 years, you’ll earn 1.6% a year. If inflation averages 10%, you’ll earn about 11.6%. And so on. You get the picture.

The story is similar the longer the TIPS bond you buy. If you buy a 10 year TIPS bond you’ll earn about inflation plus 1.4% per year, and if you buy a 30 year TIPS bond you can earn about the same.

Maybe TIPS bonds will prove to be a great bet over the next 5 or 10 years or longer. Maybe not. But, mathematically, the only way they can prove to be a worse bet than regular Treasury bonds is if inflation comes in really, really low. And I mean average inflation, starting right now.

Hence the “bet” with which I began this article.

Five year TIPS bonds will be a better bet than 5 year regular Treasurys only if inflation averages less than 2.4% over the next 5 years. Ditto 10 year TIPS bonds and 10 year Treasurys. For that to happen, inflation doesn’t just have to decline. It has to collapse, and pretty fast, too.

And, even worse, anyone buying the regular Treasurys instead of TIPS is taking an asymmetric risk. Buy a 5 year Treasury yielding 4%, and if inflation collapses in short order you could, in theory, end up making maybe 1% a year more than you would make on the TIPS bond. But if inflation stays high, or even (heaven forbid) gets worse, the person buying the regular Treasury bond gets hosed. You’ll be locking in 4% a year for 5 years while consumer prices rise by, say, 8% or whatever.

There are simple mechanics that partly explain this bizarre situation. Big institutions, passive investors, and financial advisers worried about their own liability instinctively buy regular Treasury bonds over TIPS: They are considered the default, “risk free” asset for no better reasons than that they have always been, and are the biggest and most liquid securities in the world. It’s hard to get sued for putting your clients into Treasurys.

The total market for regular Treasurys is more than 4 times the size of the TIPS market, and daily trading volumes are enormous.

Furthermore, TIPS bonds have never been needed before now. The British government invented the concept in the early 1980s, after the inflationary disaster of the 1970s, and our own Uncle Sam not until the late 1990s. So far, TIPS bonds have only existed during an extended period of deflation, when they have proven OK but less good than regular, fixed-interest Treasurys. During recent panics during the deflationary era, such as the 2008-9 crash and the Covid crash of 2020, TIPS bonds fell.

It’s probably hard to sell fire insurance to people who’ve never experienced a fire and never seen one, especially if the fire insurance itself is a new product that was only created long after the last big conflagration, so it has never paid out. Ditto inflation insurance.

Late last week I asked Steve Russell about this. Russell is an investment director at Ruffer & Co., a London-based money management firm that successfully avoided the 2000-3 and 2007-9 market meltdowns. (Ruffer has been worried about inflation for over a decade and is heavily invested in inflation-protected bonds: Make of that what you will.)

Calling the TIPS yields “incomprehensible,” Russell says he suspects “market myopia and clinging to past orthodoxies.” As he puts it, the bond market’s inflation expectations have stayed broadly flat all year “as if the current inflation never happened.” Bond investors are confident the Fed can and will do “whatever it takes” to bring inflation back down to the old 2% target, and will do so pretty quickly.

Russell does not believe that is going to happen. He thinks the Fed is going to find the economic cost of hiking rates too high. He also thinks the world is now much more inflationary than it used to be, due to a variety of factors, including Ukraine, onshoring of manufacturing, and the strengthening power of labor.

(Interestingly, while here in Britain I noticed that multiyear cellular contracts here now include an inflation rider, with rates rising by inflation plus a few percent every year. Before the Covid lockdowns, cellular contracts were generally defined by deflation, not inflation.)

TIPS bonds have performed terribly so far this year, even as inflation has surged. This is precisely because the market is still expecting an imminent collapse in inflation. Furthermore, TIPS bonds began the year overpriced: They were so expensive that many of actually guaranteed a “negative real yield,” meaning inflation minus a bit, until maturity.

Bonds are like seesaws: When the price falls, the yield or interest rate rises. The plunge in TIPS prices this year has resulted in much fatter, and now positive, real yields.

One caveat is that TIPS prices could continue to fall, driving real yields even higher. Such inflation-adjusted yields used to be north of 2% and were sometimes even higher. So if you consider TIPS to be a good deal now, there is nothing to prevent them becoming an even better deal in the future.

Those who invest in TIPS via a mutual fund will have to accept that volatility as part of the deal. TIPS may fall still further if recent market trends continue. On the other hand, if you buy individual TIPS bonds (available through any broker) and hold them to maturity, the volatility won’t matter so much. You’ll get the guaranteed “real,” inflation-adjusted yield over the course of the bond.

One curious feature of U.S. TIPS bonds (but not overseas alternatives) is that they are always guaranteed to be redeemed at face or par value when they mature, even if there has been massive deflation. So it generally makes sense to buy individual bonds close to par value if you can.

Incidentally, due to tax complications, it is generally preferable where possible to own TIPS in a sheltered account such as an IRA (Roth or traditional) or 401(k).

Mindful of Stengel’s dictum, I don’t make predictions. But I have been buying TIPS bonds in my own IRA and 401(k), not because I want to make forecasts about inflation but because I do not want to make forecasts about inflation. I see no reason to make risky, asymmetric bets on an imminent collapse in inflation through regular Treasurys when I can get a small but guaranteed interest rate on top of inflation, whatever it turns out to be.

Source: https://www.marketwatch.com/story/want-to-gamble-your-savings-on-a-quick-collapse-in-inflation-11664202818?siteid=yhoof2&yptr=yahoo