Published Wednesday, October 7, 2009Published Wednesday, October 7, 2009
by Stephen Butler
Don't look now, but Treasury Inflation-Protected bonds (TIP's) may be a trap for the unwary. They're certainly good for the government, because the interest cost on TIP's is half of what it takes to sell a regular fixed-rate, 10-year government bond.
Money has been flooding into this 10-year-old financial invention on the premise that future inflation will trigger a dollar amount increase in the bond's principal. The increase will be a direct reflection of the cost-of-living increase.
For example, if you buy a $1,000 TIP and inflation turns out to be 10 percent in a year (remember the 1980's?) then your bond's capital value would be adjusted to $1,100. In the meantime, you would be receiving an interest payment equal to about 2% currently of the original $1,000 -- about $20.
Right now, the interest rate on 10-year TIP's is 1.8 percent and the interest rate on regular 10-year bonds is 3.6 percent. The "invisible hand" of economic forces is trying to show us something here. Collectively, everyone buying a 10-year, fixed-interest bond is assuming that today's fixed interest rate of 3.6% is a fair deal. If 10-year bonds typically pay a rate that is 2 percent above the expected inflation rate, then inflation is expected, by today's bond buyers, to average about 1.6% per year for the next 10 years.
Since TIP's right now pay an interest rate of only 1.8 percent, this says that the inflation-rate assumption for TIPS is the difference between 1.8 percent and the 3.6 percent which the world of bond buyers considers a good value.
Confused? In other words, TIP's investors will accept an interest rate of only 1.8 percent today because they know the government will increase the capital value of their bond by as much as the rate of inflation. This is where the other 1.8 percent comes from to bring the total to the 3.6 percent market rate for 10-year, fixed rate bonds. If the public thought that inflation was going to be a lot more, it would be quick to buy TIP's that paid even less interest today. If today's bond buyers are wrong, and inflation soars, the TIP's buyers will make a lot of money. If we have deflation, they could actually lose money.
For us amateur, self-styled economists convinced that inflation will run rampant because of huge government debt, there is an alternative to TIP's that will protect us if we're wrong.
It would be short-term corporate bond funds with average bond maturities of about 2 years. Vanguard's short-term corporate bond fund is now paying a yield of 2.8 percent. Short maturity means that if inflation comes on strong, new bonds rapidly added to replace those that reach maturity will be paying the higher inflation-driven interest rate. With a spike in interest rates, it would take about a year for the fund's turnover to bring on enough bonds at the new higher rate to raise the average coupon to an acceptable level, but a year goes by pretty quickly. In the meantime, until that event does happen, we have an investment that can make better sense than a money market fund paying negative rates or TIP's that currently amount to a gift to the government.
In my mind, TIP's fall into the same category as Roth IRA's and 401(k)'s. Both are tools invented by our government to improve immediate cash flow by saving money on today's interest costs (TIP's) or by generating tax revenue sooner (Roth.) The government, like the casino industry, has the odds stacked in its favor. There's always the chance that we might win when using one of these new incentives, but the fates statistically rule against us. Government statisticians have figured this out.