The Wall Street Journal reported today that the economic recovery is driving people to Treasury Inflation-Protected Securities (TIPS) (“But with economic growth comes the prospect of inflation. This is what perhaps fueled interest in TIPS, despite their negative yields.”). Investors are willing to accept negative yields on TIPS in the belief that the expected protection against inflation is worth the tradeoff.  I believe it isn’t.  Think about it.  While TIPS are guaranteed to match whatever Consumer Price Index (CPI) statistic prints during the bond’s lifetime, the “reward” for investors will probably be to lose a little bit after inflation–with certainty.

Then, it gets worse.

Conventional Treasury bond yields can be thought of in two parts—the “real” yield (the difference between a bonds current yield and the rate of inflation) and the part that compensates you for the possibility of inflation. Both of those components can change.  Either or both can rise or fall, thereby lowering or raising the market value of the bond.  Right now, the 5-Year T-Note will beat inflation if it comes in at 2¼% or less, while TIPS will match inflation at any level.  What I worry about is the real yield part.  The real yield rate is the true cost of money.  It’s what the government should have to pay for the privilege of your money.  It’s what the government needs to pay to pry you away from alternatives that may pay a better return.  Right now, the real yield is slightly less than zero for both conventional Treasuries and TIPS.  Less than zero…can that be right?  Put another way, which number looks too low—a 2¼% inflation rate for five years or a zero real cost of money? You probably said both look too low. But in my view, it’s the real yield number that certainly looks wrong.

I believe the danger lies in dashed expectations.  Most folks hear the phrase “inflation protection” and derive comfort from it.  But how will they feel if real rates rise in the recovering economy and prices of TIPS fall nearly as much as conventional T-Note prices?

During the last phase of Fed tightening, from 2004 to 2007, 10-year T-Bonds rose in yield, trough to peak, by roughly 120 basis points, delivering price losses to their holders in the neighborhood of 8%.  How did TIPS do?  They rose in yield by about the same amount, delivering the same kind of losses.  This is the real yield effect.  If the Fed falls behind the curve, TIPS will lose less than conventional Treasuries, but still lose as real yields rise anyway. TIPS do protect against inflation, however, and that will probably always be true.

When deciding on the best way to protect yourself from inflation today, you have to consider the other valuation drivers of the investment.  Negative real yields means TIPS and conventional Treasuries are poor choices right now.  Equities, which are clearly cheap compared to bonds, have a better chance of delivering a real return and keeping pace with inflation.

TIPS Sell at Negative Yield for Second Time Ever

http://online.wsj.com/article/SB10001424052702304724404577297702937642324.html

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Inflation-indexed debt securities are bonds structured to seek to provide protection against inflation. If inflation declines, the principal amount or the interest rate of an inflation-indexed bond will be adjusted downward. This will result in reduced income and may result in a decline in the bond’s price which could cause losses for the Fund. Interest payments on inflation-protected debt securities can be unpredictable and will vary as the principal or interest rate is adjusted for inflation. Inflation-indexed debt securities are also subject to the risks associated with investments in fixed income securities.

Bonds are exposed to credit and interest rate risks (when interest rates rise, bond/fund prices generally fall).

Equities are subject to market risk and volatility; they may gain or lose value.