Features and Risks of Treasury Inflation Protection Securities

Kansas City Fed: Features and Risks of Treasury Inflation Protection Securities
These assets have virtually only one risk: the risk that the real interest rate prevailing in the market will change. In contrast, all other financial assets currently available embody more than one risk. In particular, conventional Treasury bonds have both real interest rate risk and inflation risk. Thus, Treasury indexed bonds provide investors with a safer asset than has historically been available.

So let's talk about that primary risk. The risk here is that real returns rise and we'll be stuck with an inferior rate. Just how bad is it though if we're investing for the long-term? Let's say we have a 10-year TIPS yielding 2% over inflation and we'll hold it until maturity. Now let's say we fall asleep for 10 years and awake to see how we did.

Since we held until maturity, we got 2% over inflation. We knew that before we fell asleep. No big surprise there. So what are we hoping to see now that we've woken up? We want to see much higher real rates so that we can reinvest in even better yielding TIPS and go back to sleep for another 10 years! If rates are actually lower, we're going to be less happy, right?

So how does this real return risk work in the real world? If interest rates rise the 2% TIPS will become worth less to others. Who wants to be stuck earning 2% over inflation when you could be earning 3% over inflation? Oh well! Cry us a river. If you buy a TIP fund (or try to sell your 2% TIP in the secondary markets before it matures) you will feel that missed opportunity cost directly. You can lose money if you don't keep a long-term perspective. However, a TIP fund is simply a collection of TIPS. In the long-term, if you are comfortable owning TIPS, then you should also feel comfortable owning the fund. That being said, this real interest rate risk is a real risk. In theory, real interest rates could continue to climb throughout your life, and the fund could suffer each and every year as a result. At some point though, the real return would be so high you'd be sitting in a prosperity generating machine though, so the odds of it being infinitely sustainable seem rather remote (especially these days).

Generally, real interest rates are highest when the economy is doing the best and lowest when the economy isn't doing so well. I say generally because real interest rates were very high during the Great Depression (since the price of goods dropped considerably). The 1970s saw negative real rates as did the dotcom bubble's aftermath. I'm bearish on real rates, for what that's worth. I think the high real rates heading into the dotcom bubble will not soon be repeated.

Unfortunately, because the tax code does not distinguish nominal income from real income, the tax burden of an investor in indexed bonds increases when inflation increases. Consequently, in terms of after-tax yield, even indexed bonds are not entirely inflation risk free.

If the government wants our wealth badly enough, it will get it no matter what we do. If it takes a wheelbarrow of dollars to buy a loaf of bread someday, TIPS would go to zero just like every other paper promise. I do not scoff at those who would make such an assertion but I'm not betting on that outcome either.

Even though the tax code brings inflation risk back to indexed bonds, the risk is small compared with nominal bonds.

The reason TIPS would be feeling tax pain during severe inflation is because they would be paying so much interest. You could certainly have worse problems to deal with, namely earning little interest by being locked in a long-term non-inflation protected treasury at a low interest rate.

I-Bonds are even safer than TIPS in my opinion, since they are tax deferred up to 30 years and therefore reduce the tax risk as mentioned above.

There is at least one more risk not mentioned. Do you trust the CPI or don't you? Can you trust it in the future? I trust it more than many, but certainly not at 100%. Even if it was 100% accurate for us as a group, it couldn't be accurate for all of us individually. We don't all spend money exactly the same way.

Once again, this isn't investment advice. I'm just trying to protect myself against a fairly worst case outcome (but not the worst case, or I'd still be in gold and silver). I'm an inflation/deflation fence rider most of the time, since I think both forces are rather powerful. I continue to be amused that the consensus of my latest poll is riding the fence right along with me (12 recession disinflation, 12 stagflation). Go figure.