Amazingly Bad TIPS Analysis

Peter Crabb: Here's a tip about TIPS: Buyers don't really expect negative interest

The price paid for these bonds at auction is such that the real interest rate will turn out to be negative if inflation doesn’t occur.

Real interest rates are GUARANTEED to be negative if inflation DOES occur. He's got this exactly backwards.

In fact, the only way these bonds could earn a positive real interest rate is if deflation strikes and the deflation protection that TIPS offers therefore kicks in.

Picture paying $1050 for $1000 bonds but then prices in general fall 50%. You'd be pretty darned pleased even though you overpaid for those bonds. You may not get the $1050 back, but $1000 is nothing to sneeze at. You'd definitely have a positive real return on your investment. You only lost about 5% as prices in general dropped 50%? Sign me up! I'd take that deal any day of the week.

Can this really be true? Would people really lend at a negative interest rate?

The answer is no. U.S. Treasury bond investors don’t expect to lose money. They expect inflation to rise, and with it, the value of TIPS.

I've got news for Peter Crabb (who has a doctorate in international and financial economics). The answer is yes. Investors expect to lose money in negative real interest rate TIPS when adjusted for inflation. They just don't expect to lose as much as some. If the investors are really smart then they are hoping for serious deflation.

If investors are actually hoping for more inflation as Peter Crabb implies, then investors really are stupid. As I have said here time and time again, inflation never helps investors in TIPS. It only hurts them. The higher the inflation, the higher the taxes on the inflationary gains and the worse the real interest rate after taxes becomes. In any event, higher inflation cannot turn negative real interest rate TIPS into something that can actually protect purchasing power.

If inflation moves back to its long-run average, these investors stand to earn much more.

Yes, and if inflation moves to 100% per year and stays there, these investors stand to earn even more than that. Much more. The taxes on all those inflationary gains will nearly financially ruin them each and every year but as Peter Crabb says, "Investors want to be compensated for it."

I own TIPS. I hope inflation remains tame. I am most certainly not rooting for higher inflation on the hopes that I can say, "I told you so." My bragging rights would pale in comparison to the lost real purchasing power due to the taxation. In fact, serious hyperinflation would transform my bragging rights into idiot's rights, as I would be forced to admit what a lousy investment TIPS had become.

And now back to the first paragraph of the article.

Is it real or not? Can investors make a real return today?

If investors are buying negative interest rate TIPS thinking that they will make a real return if inflation picks up, then investors are stupid. There's just no other way to put it.

Good frickin' grief.