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
Hi,
ReplyDeleteCan you explain the graph a little more? Why does the tax rate matter? Both TIPS and I Bonds are taxed the same way, right? (They are only subject to federal taxes.)
Hi,
ReplyDeleteThanks for the questions.
Can you explain the graph a little more?
I know my explanation is a bit weak but I tried to do a better job in a previous post. Please see the "TIPS vs. I-Bonds" link above for a more detailed description of how the chart was created.
Why does the tax rate matter? Both TIPS and I Bonds are taxed the same way, right?
TIPS and I-Bonds are not taxed the same way. You pay taxes annually on the TIPS but you can defer the taxes up to 30 years when you hold I-Bonds. This makes a big difference should the inflation rate go up in a major way and you are in a high tax bracket (and assuming you hold the I-Bonds for the full 30 years).
Okay, I'll check out your other links. How does tax deferral makes a difference regarding inflation? These are the only two things that I can think of that tax deferral affects:
ReplyDeletea.) You expect to be in a different tax bracket at the end of the 30 years vs. your average tax bracket over the 30 year period (such as if you are retired and have lower income or you expect to be very wealthly in 30 years)
b.) You expect the government to change the tax rates (almost certainly they will, but it's not possible to predict the magnitude and direction over such a long term)
Anonymous,
ReplyDeleteYou are missing the third, most important thing that tax deferral does.
If you have I-Bonds, the government can tax it just once, 30 years from now. The most they can possibly take is the amount equal to your tax rate.
If you have TIPS, the government taxes you each and every year for 30 years. The higher your tax rate, the more they can nickle and dime you to death each and every one of those years. I can assure you that at the end of the 30 years, if inflation is high enough and your tax bracket is high enough, the government would can take the vast majority of your investment in taxes (and have created charts to show the effect).
Tax deferral can be a very, very good thing during periods of high inflation and/or high taxes.
Okay, I thought they were mathematically equivalent, but after trying it out in a spreadsheet program, it seems you are right. Thanks!
ReplyDeleteI'm glad it helped. :)
ReplyDelete