The Death of Real Yields v.4

The march downward continues. TIPS (treasury inflation protected securities) do best during periods of stagflation, simply because they do best when real yields fall. It does not matter why real yields are falling. It could be because interest rates are coming down faster than inflation or it could be because inflation is rising faster than interest rates.

The yield on the 10 year TIPS is nearing the 2004 low. Part of me is thinking of profit taking. Part of me is thinking the aftermath of the housing bubble will be far worse than the aftermath of the dotcom bubble though (in inflation adjusted real terms anyway). Therefore, I am still comfortable holding.

TIPS didn't exist in the 1970s. Real yields on non-inflation protected treasuries were negative though. It is conceivable that the yield on the 10 year TIPS could actually reach zero should our economy continue to stagnate. Zero is the lowest it can go as seen in the Treasury Marketable Securities Tender Instructions (and we're well over one third of the way there already).

Note About TIPS: Should the accepted auction yield be 0% or less, the security will not have regular semiannual interest payments. The yield will be adjusted for inflation throughout its lifetime, thus posting changes at maturity (or sale). In this case, where the accepted auction yield is 0% or less, the interest rate will automatically be set at 0% (never anything lower) for all buyers.

Note that you will still lose money to taxes though. The government wants its cut in good times and bad. Should inflation reach 10% you'll be earning 10% (but also paying tax on that 10%). Of course, if inflation hits 10% you could probably be doing far worse (if the 1970s are any indicator). I'm working under the assumption that we're in a bear market and that the goal is to simply lose less money. How's that for pessimistic?

I-Bonds are yielding a real rate of 1.2% and will continue to do so at least until May, 2008 (once you buy the I-Bond that real rate is locked in for as long as you own it though, up to 30 years). As the TIPS rate falls, the I-Bonds become more and more attractive by comparison (since they are tax deferred). Further, should real interest rates climb higher you can always sell the I-Bonds (without taking a loss, unlike TIPS) and reinvest at the higher rate.



This chart shows the total real return difference between the 1.61% 10-year TIPS continually reinvested (at that same 1.61% for 30 years, assuming interest rates held steady) vs. the 1.2% I-Bonds (held for 30 years) depending on the tax bracket. It is an update to a chart I've done previously. As can be seen, the TIPS should do better than I-Bonds if inflation stays tame (big if!!) and/or you are in a relatively low tax bracket.

I have no crystal ball on where real interest rates are heading next. If I knew for certain, I wouldn't be sitting in TIPS. I'd either be hoarding hard assets (gold and silver) or shorting hard assets (or at the very least selling my house and renting, which has at times crossed my mind).

In any event, this is certainly not investment advice.

See Also:
The Death of Real Yields v.3
TIPS vs. I-Bonds
Features and Risks of Treasury Inflation Protection Securities

Source Data:
FRB: Selected Interest Rates
Treasury Direct: I Savings Bonds Rates & Terms
Forms - Treasury Bills, Notes, Bonds, and TIPS