Home > Bond Market, CPI, TIPS > Fair is Fair, and TIPS are There (Almost)

Fair is Fair, and TIPS are There (Almost)

For a very long time, I have been writing in our Quarterly Inflation Outlook that TIPS were “relatively cheap, but absolutely expensive.” By that I meant that TIPS real yields at -1%, -2%, etc were not exciting (implying as they did that a buyer would have long-term real wealth destruction), but that compared with nominal Treasury yields of 1%, 1.5%, or 2% any investor in fixed income should have vastly preferred TIPS.

I have repeatedly said – as far back as 2016 – that with breakevens below 1.5% there wasn’t even a decent strategic case to own nominal bonds rather than inflation-linked bonds (ILBs) except to defease specific nominal liabilities and that at times those low breakevens meant that owning nominals instead of ILB amounted to a really big bet (as I said in this article from March 2020). Those are relative concepts.

But 10-year real yields were below zero, and as low as -1.2%, for most of 2020, 2021, and the first half of 2022. And 10-year real yields have been below +1% almost continuously since 2011. When real yields were below zero or just fractionally positive, it meant that TIPS were absolutely expensive. That wasn’t just a TIPS problem of course: low real yields were the most obvious in TIPS, but you couldn’t avoid them by trafficking in other asset classes because they were a characteristic of the environment we were in. Everything was absolutely expensive, but TIPS were at least relatively cheap.

More recently, our models indicated TIPS getting quantitatively fair on a relative basis, which is historically unusual (see chart, source Enduring Investments); they even got somewhat rich a couple of months ago and that’s historically unheard of.[1] Real and nominal yields were still low, but at least it was a fair horse race between which ones to hold. And if you’d bought TIPS when I said there was “a big bet” being made against them, and sold them when we said they were fair, you crushed a nominal portfolio’s return. (As an aside, the rich/cheap chart and value is available every day on my private Twitter feed. Sign up for that private feed here: https://inflationguy.blog/shop/ I keep adding more charts etc, in addition to the main event, my live CPI report coverage each month).

As of today, 10-year TIPS yields are all the way up to 1.67%, the highest they’ve been since 2010. I explained back in June why the equilibrium risk-free real interest rate is approximately 2.25%, so TIPS are getting to the neighborhood of long-term fair values in an absolute sense. TIPS have no risk in real space, when held to maturity, so if you can get an annual 2%ish real increase in wealth with no risk, that’s a good deal. And inflation-linked bond yields in developed markets basically never yield more than 4% or 4.5%, so the higher the yield goes the less your potential mark-to-market downside. A 5-yr or 10-yr TIPS yield of 4% is back-up-the-truck stuff if you see it. At those real yields, with no risk, other asset classes simply can’t compete. At 1% breakevens there was no reason to own nominal bonds rather than TIPS; at 4% real yield there would be no reason to own stocks rather than TIPS.

But that sort of yield is of course very rare and we won’t see it unless nominal yields get up to double-digit land. At the current level, with TIPS at fair or slightly-cheap relative value and approaching fair absolute value, it is worth accumulating TIPS as a long-term hold.

It has been an astonishingly long time since I could make that statement. And TIPS may well get cheaper from here. I hope they do! But in the meantime, you can do a lot worse than guarantee yourself that your wealth will increase 18% more over the next decade than the price level rises.[2]

[1] I have written previously though about the value of long inflation tails, and how that value is NOT reflected in TIPS so that even when our model says TIPS are fair, they’re still very cheap if that tail option is reasonably valued. But that isn’t included here.

[2] (1+1.67%)^10 – 1 = 18%.

Categories: Bond Market, CPI, TIPS Tags:
  1. September 30, 2022 at 9:32 pm

    What about investing in a TIPS fund? Price has been dropping with the rise in nominal rates.

    • October 3, 2022 at 8:46 am

      The problem with a TIPS fund is that you never get the principal, so you’re perpetually exposed to rising real rates. At this level, that’s about a fair bet though.

  2. Rob
    October 1, 2022 at 2:27 am

    I show that the SPIP ETF has a nominal yield of over 8%, is that accurate? Seems almost too good to be true

    • October 3, 2022 at 8:45 am

      I am not a spokesman for them but wouldn’t surprise me at all with inflation at around that level. But that’s backward-looking and not a very good indication of what next-year’s dividend will be.

    • October 3, 2022 at 11:28 pm

      Doesn’t the 8% yield likely come from expiring Tips rolling off (or being sold to track an index, in the case of LTPZ), and therefore a holder of the fund *does* benefit from increase in principal?

      • October 4, 2022 at 6:02 pm

        No. The TIPS principal increases with inflation – but that’s considered an interest return, not principal. The fund holder definitely benefits from an increase in principal – what they don’t benefit from is the pull to par, because they never get to maturity (if they held to maturity, you’d always have part of the index that is maturing, but you’d always have an exposure to real rate changes in the rest of the portfolio. Plus, the indices all drop TIPS once they get to 1y of maturity, so in practice these funds rarely hold TIPS that short unless it’s a vehicle for that purpose, like VTIP).

  1. No trackbacks yet.

Leave a Reply

%d bloggers like this: