Bottom line: Real return on TIPs going forward is negative.
It is true that TIPs (and the ETF TIP) have returned about 12% in the past year. This is mostly due to the increase in market price of the individual TIPs (I have two of them, maturing in 2016 and 2019).
Here's the problem: The market price of these individual tips will, by definition, be 100 (% of face value) at maturity, no matter what the price is today. The face value will, of course, be higher than today by the ratio of the CPI at maturity over the CPI today. Arguments over whether the CPI is a true measure of inflation are beyond the scope of this discussion...
So let's just take a specific example - my 2% TIP maturing in January, 2016. It's price today is 111.9, or 11.9% above face value today. At maturity, in January, 2016, the price will be 100. So between now and January, 2016, the market price must fall by 8.9% (100/111.9).
I'll spare you the math, which involves a few logarithms if you assume continuous compounding (a great simplification), but just on your fingers you can divide 8.9% by four years to get 2.23% per year of price depreciation on an asset that returns a nominal 2.0% per year. That means the "real" (that is, after inflation) return on this TIP is about -0.23% per year.
(If you do the math with logs it's actually -0.8%)
So, for that particular TIP, I am paying 0.8% per year to protect myself from inflation till 2016. I guess that's OK.
What about TIP? It holds a bunch of different TIPs with different coupons and different maturities, and it either buys or sells these depending on inflows or outflows of money (lately they have experienced significant inflows), so things are a lot more complicated. However, if we applied the above calculations to each of their holdings, I expect we would come to the conclusion that TIP, held "long term" (years) will return CPI±2%, or in real terms, 0±2%.
I don't know - in these treacherous times, maybe 0±2% isn't bad.
especially if we enter a recession in the next few months<<
Every time the US 10 year treasury note went negative since 1957 (compared to the CPI), this has been followed by a recession. The rate turned negative in January 2008 and we officially were in recession by April 2008.
The 10 year note went negative in June 2011 this time--waiting :).
Thanks Ken for you explanation. I wish you good luck.
Bottom line for me is that over a three year period TIP has a very strong negative correlation to the US dollar (using UUP).
Of all the things I can find that are US dollar negative, TIP may have the least amount of upside potential now and especially if we enter a recession in the next few months. I've seen how TIP reacts to a whiff of deflation in 2008 and to a lesser extent summer 2011. I'm betting against it because of that--I could be wrong and wish no one here any harm--that is how markets are made.
There is one thing in play here with this TIP fund vs individual TIPs that could be what you talked about when you said that when a crisis hits, the TIP fund seems to get hit too.
The TIP fund is a blend of many expiration TIPs. Most of those individual TIPs that go into the fund were bought during times when there is not these immediate "crisis" that you say (and I agree) hurts the market price of the fund.
Relative to TIP issued during the "crisis" times, the rates of return are higher. People expect a higher rate of return during times of risk. Why does this seem to drive the TIP fund price down?
Easy....who would want to buy a blended fund that is averaged at a lower rate than what would be available right off the street at a higher rate? Who wants to lock in the low rate of the TIPs fund when they can go into the open TIP market and purchase higher yielding TIPs for a shorter duration. Ergo...the buyers of TIP funds shun it, the market price for TIP fund goes down. But this effect is normally only for the short term.
As the immediate crisis eases, so too does short term issue price of each TIP maturity. As well, the TIP fund goes through its rotation out of maturing lower rate funds which are being swapped out for the relatively higher TIPs during this short term crisis. The blended return rated then inches up...albeit slowly, for the TIP bond funds.
Then as the immediate crisis goes away, the attractiveness of the TIP bond fund re-emerges with the slightlyhigher blended rate. Buyers then push the market price of TIP bond funds to the upside....this is the phase we are in today.
As the next immediate crisis hits, the rates of return of the the individual govt issued TIPs rolls up, the attractiveness of locked-in, longer term rates (such as those of the TIP bond Fund) established during the non-crisis mode is lessened, and so too will the market price of the bond fund TIP.
When the dollar is stronger and other currencies are weaker, guess what happens to TIP? It moves up because people are buying into a stronger investment to lock in some sort of rate....no matter how low it may be. And at the very least, try to protect the principal from erosion.<<
Actually the biggest move that TIP has had recently is when the US dollar was FALLING. It really is an anti-US dollar investment.
When the US dollar strengthened in 2008, TIP got clocked.
Thank you for your response. I am always interested in the thoughts of someone who trades/invests with a purpose. Understanding the goal, may help me in understanding its applicability to me or others.
You referenced a situation in Europe that seemed to always hit your investment in TIP. Each time the Europeans were hit with some economic issues you mentioned that the price of TIP was hit. You seemed perplexed or at least frustrated.
I believe that it is nothing more than a flight to quality (relative to the economy of Europe) that is causing this. Funds naturally flee unsettled economies and go toward the more stable economy. In this case, when Europe gets hit, people sell European based instruments and move them toward the more stable (relatively speaking) economy....which would be in many cases the U.S. economy.
When the dollar is stronger and other currencies are weaker, guess what happens to TIP? It moves up because people are buying into a stronger investment to lock in some sort of rate....no matter how low it may be. And at the very least, try to protect the principal from erosion.
If you think the Fed has driven the rates low (ridiculously low)...think Japan...they are at a negative rate and have been at or below Zero for a couple of years.
I like market timing. I have been trading based on technical indicators (stochastics, RSI and MACD among a few of my favorites) for 30 years now. Nothing mysterious to me there.
Good Investing, Ken
Nice discussion guys--I've often wondered what TIP really was and have settled on a "safe" version of SPY, for lack of anything better. I certainly don't like it at the 20% level on the chart above and like it more below zero :).
SPY correlation to TIP over a three year time frame is .73 which is just below some of the "X" index funds like XLF, XLU.
The Federal Reserve recently announced that they will continue to keep the fed funds rate near zero until the end of 2014, in an attempt to pump up the economy with free money. I hope it works better here than in Japan – where a near-zero interest rate policy has failed to boost their economy for more than TWENTY YEARS now. The Fed’s policy means that retirees (like myself) and other savers will continue to be punished with bank interest rates well below the inflation rate. Gone are the days when we could buy a “ladder” of treasury bills or 5-year CDs and gain inflation-beating returns. So for lack of good alternatives, we have inflated the price of TIPs and bonds in general to where we are guaranteed to get negative real yields going forward.
Not exactly the right formula. It's even better that you think. The inflation component is added to the principle each year / or six-months and it is compounded each year and figured on the previous ending principle balance each future calculation. So the next inflation protection addition is figured on the previous ending balance, as it the small interest income. So your formula should have indicated a summation on 30 or 60 usually growing principle balances times 30 years worth of changing CPIs.
You are correct sir.
Most people don't understand how TIPS work and how a good thing they really are, including myself until I educated myself about how they work recently. Their performance since they were introduced proves this out clearly. Compared to MM, CDs, or even AAA bonds they are a much better deal and they provide excellent protection in almost any scenario. They are an almost "no lose" proposition, unless the world as we know it comes to an end.
So, my question is, how does an investor who purchases TIP at today's price know what he's paying for inflation protection given that TIP invests in many Tips with different maturities and yields ?
Absolutely not. They have no idea what they are buying or how much it is costing them.
New TIPS from Treasury are being issued with negative fixed rates. How does that work?