TIPS: Long-Term Risk vs. Reward

An Empirical Decomposition of Risk and Liquidity in Nominal and Inflation-Indexed Government Bonds

Over the 10 year period starting in 1999 the average annualized excess log return on 10 year TIPS equaled a substantial 4.16 percent, almost a full percentage point higher than that on comparable nominal US government bonds.

In general, insurance costs money. TIPS offer some inflation protection and protection is a form of insurance. However, TIPS investors have been paid to take this insurance.

I will simply repeat my long standing theory on why this has been true.

Investors who fear serious deflation will buy nominal treasuries. Investors who fear hyperinflation do not buy inflation protected treasuries though. They buy hard assets instead. In other words, at least some of the money that would consider buying TIPS during inflationary periods has been diverted elsewhere.

This is why I believe that there is error introduced when trying to determine inflation expectations from the difference in yields between nominal treasuries and treasuries with inflation protection. If my theory is correct, then actual inflation would tend to be higher than the bond market's expected inflation. This is what we have seen.

Over the long-term, higher inflation than expected would therefore reward TIPS buyers over those who buy treasuries without inflation protection.

The authors find strong empirical evidence for two different potential sources of excess return predictability in inflation-indexed bonds: real interest rate risk and liquidity risk.

There's no mention of my deflation/hyperinflation theory here of course. I'm not a Harvard economist. You won't be able to find proof of my theory in a data table. I'm relying on common sense and anecdotal evidence based on my own purchases. So let's discuss their reasons.

* Real Interest Rate Risk: This is something I have been comfortable with over the long-term, mainly because I thought real rates would fall (as our economy stagnated). That risk therefore turned into a reward.

* Liquidity Risk: This is a very minor risk for me. I buy and hold until maturity. I'm not intending to require a greater fool to buy these long-term TIPS bonds back from me. I'm not immune to the risk though. There is some here. I may be forced to sell someday for reasons outside of my control.

The primary reason I would be forced to sell TIPS would be if inflation became so high that I'd have to sell some TIPS just to pay the taxes on the inflationary gains. As far as my personal finances are concerned, I would therefore argue that TIPS have LESS liquidity risk than nominal treasuries. If inflation was running that hot then I'd have a much easier time finding buyers for TIPS than those selling treasuries without inflation protection.

In conclusion, I believe that long-term TIPS offer better risk adjusted returns than long-term nominal treasuries. I have felt that way for the past decade and I continue to believe that looking forward. That may not be true in the short-term though. As seen in the upper left hand corner of my blog, I tend to lean a bit deflationary right now.

Here's the real benefit of TIPS to me. I can hope that I am wrong. As a holder of TIPS I would love to see inflation average 0% for the rest of my life (much like Japan has done over the past decade or so). At least I would not have to pay tax on the inflationary gains. From a purchasing power perspective, I would not be doing as well as those holding nominal treasuries but I'd still be doing quite well.

Disclosure: The bulk of my nest egg sits in TIPS and I-Bonds.