In 1997, the United States Treasury Department introduced securities designed to protect fixed income investors against future inflation. As investors know, the most insidious risk borne by bond investors is having their future coupon and principal payments devalued via inflation that diminishes the purchasing power of their investment. Treasury Inflation-Protected Securities (TIPs) include an important feature not previously offered by other Treasury securities: inflation indexing. This feature protects investors in periods of inflation by adjusting bond principal in accordance with changes in the US Consumer Price Index (CPI). CPI is not a perfect representative of cost of living realities, but it is the most widely-regarded domestic inflation measure. With over $550 billion in TIPs outstanding, these financial instruments make up the largest inflation-indexed securities market in the world.

Inflation: The Invisible Enemy

The first hurdle for any investment to clear is keeping pace with inflation. Inflation is simply the rise in the cost of goods and services over time. The primary index used to follow inflation, the CPI, tracks changes in the historical cost of a basket of common goods and services, thus providing a basis to calculate inflation statistics. The changes in the costs of these goods and services can be aggregated into an annual, year-over-year change percentage. This percentage is what the market usually refers to as the “inflation rate.” The next graph illustrates the year-over-year rate of inflation since 1910:

While a variety of economic theories exist regarding the causes of short-term and mid-term inflation, most economists agree that long-term inflation is primarily driven by monetary policy. In general, as money supply grows, so will inflation. All things being equal, when government prints new bills and issues new money into the system, a dilutive effect occurs, all bills are worth less, and inflation ensues. The purchasing power of each dollar is weakened. Note: we make this point for simple illustrative purposes; in reality the mechanisms and effects of monetary policy adjustments are far more complicated.

As mentioned before, keeping pace with inflation, also known as capital preservation, is a basic investment goal. To meet this basic objective, an investment’s rate of return (the nominal rate) less the rate of inflation must produce a real rate of return greater than or equal to zero. For example, a 5-year CD with a nominal yield of 4.30% will only produce a measly 0.50% real rate of return after subtracting a 3.8% rate of inflation. A savings account with a 1% interest rate actually yields negative real return after subtracting out the same inflation figure.

The genius of the TIPs investment vehicle is the investor is completely insulated from inflation risk. If a period of high inflation occurs due to uninhibited monetary policy, the investor is protected through inflation indexing. The mechanics of this indexing will be explored next.

The Nuts and Bolts of TIPs

In a perfect-world environment where no inflation exists, there are only three important components to a TIPs instrument: the principal balance, the coupon rate, and the holding period. For new issues, the minimum purchase for TIPs starts at $100 and can be increased in $100 increments. The coupon rate, which is the stated rate of interest provided at the bond’s issuance, is multiplied by the principal balance to arrive at the interest payment. TIPs can be held for 5-, 10-, 20- and 30-year periods.

The TIPs mechanics become slightly more complicated when inflation is introduced. For a period where the CPI indicates that inflation has occurred, the first effect on the TIPs instrument is that its principal is multiplied by 1 + the rate of inflation to arrive at a new principal balance. For example, if the inflation rate is 5% for the period, the existing principal balance would be multiplied by 1.05 to arrive at the new balance ($105, in the case where the starting balance is $100). Second, the new principal balance is multiplied by the original coupon rate in order to create an inflation-indexed yield. In this example, if the original coupon rate was 3%, the inflation-indexed yield would be $3.15 ($105 x .03) rather than $3.00 ($100 x .03). Upon maturity of the bond, the investor will also receive the inflation-indexed bond principal.

The Mechanics of TIPs Bonds

Inflation has been the norm for the American economy. In some periods, deflation, the overall reduction in the cost of goods and services, does occur. In these situations, TIPs principal is adjusted downward by the CPI figure, and thus the resulting bond yield is also reduced. However, under no circumstances does the principal amount owed at maturity fall below 100.

A Solid Tool for a Sound Portfolio

In every well-diversified portfolio, some portion should be allocated toward the capital preservation objective. For retirees, the percentage of these investment vehicles may be high along with income-producing investments. For younger investors, these tools may take a backseat to investments in the aggressive-growth category. Using TIPs as a capital preservation tool is an excellent way to diversify portfolios and take advantage of low correlation relationships with other investments such as stocks and traditional bonds. Low correlation among portfolio exposures helps reduce volatility and smooth out overall portfolio yields.

Further, TIPs are backed by the full faith and credit of the United States government. Even with current budgetary problems at the federal level, the U.S. still has one of the most stable governments in the world, with enormous taxing ability. At the current time, it is unlikely that the government would default on any outstanding bonds.

Placing Your Bet on Inflation

If an investor decides to purchase a TIPs instrument, he or she may be surprised initially to see that the stated yields for TIPs, or the coupon rates, are lower than the stated yields for non-indexed Treasuries. Why is this the case? It is all about who is bares the risk of inflation. For a non-indexed Treasury, the investor is taking the risk of a severe upswing in inflation. The rate received on a non-indexed Treasury will remain the same regardless of the level of inflation. So, a normally attractive 5% return in an environment with 10% inflation would become an investment nightmare. Thus, the Treasury is willing to offer a higher yield on non-indexed bonds in order to push this inflation risk onto investors. For TIPs, however, the inflation risk is assumed by the Treasury. The Treasury is on the hook during periods of unhinged inflation. Thus, investors should accept a lower stated interest rate if the Treasury assumes this risk.

The difference between stated yields at a point in time on a non-indexed Treasury securities and TIPs is an important figure and market indicator. Many investment professionals call this difference the market implied “breakeven inflation rate.” If average annual inflation during the TIPs holding period is higher than this figure, the investor wins. If the figure is lower, the Treasury wins. At any point in time, this figure is an indicator of market expectations for inflation.

Breakeven Illustration #1

For example, as illustrated in “Breakeven Illustration #1?, the difference between the yields on a non-indexed bond yielding 4.5% and on a TIPs note with a stated yield of 2.5%, is 2%. Thus, 2% is the breakeven inflation rate in this scenario. If inflation averages 3.5% over the period of the note, the investor will receive an adjusted yield of 6% (the 2.5% stated yield + 3.5% for inflation). This yield is higher than the 4.5% that could have been received on a non-indexed note – the investor wins. So, any rate of inflation in excess of the breakeven inflation rate (2% in this example) will result in a superior return to the TIPs investor (see “Breakeven Illustration #2).

Consequently, the decision to invest in a TIPs note essentially is a bet on inflation. The Treasury issues these notes betting that inflation will not exceed the breakeven rate. The investor acquires TIPs betting in the opposite direction. With long-term inflation so heavily dependent on monetary policy, it’s up to the investor to analyze the economic and political environment to arrive at an educated guess of the severity of future inflation.

Breakeven Illustration #2

Looking into the Inflation Crystal Ball

Prior to the creation of the TIPs market, economists used a variety of economic data and leading indicators to predict inflation; the unemployment rate, housing prices, and energy prices were such measures. While many of these figures are still useful, the TIPs market has unintentionally created new, profound insights into the future expectations of inflation. Inflation hints abound both at the time of issue and during secondary market trading.

As previously discussed, when the Treasury issues new TIPs bonds, an appropriate gap, or breakeven inflation rate, is created between stated yields on nominal and inflation-indexed bonds. Simply by issuing new TIPs instruments, the Treasury is making a bold, public statement on its predictions for inflation.

After the initial offering of new TIPs issues, the bonds may trade in the secondary market, much like stocks would trade on a stock exchange. These bonds may then trade above or below par value, depending on 1) changes in interest rates and 2) changes in investor inflation expectations. Thus, inflation-indexed bond pricing in the secondary market offers a unique insight into future inflation by directly factoring into valuation an additional key component – public sentiment.

Public sentiment, as any seasoned investor will concur, can have a heavy hand in mispricing investments. Investor emotions ran wild in the tech bubble of the late 1990s and in the housing bubble of the last decade. Now, it appears that widespread, public-denial of the effects of current governmental policy will lead to the next great financial fiasco – the bubble of the U.S. Dollar.

The Last Safe Haven

The future of the U.S. Dollar is in question. To keep inflation and the purchasing power of the dollar under control, the growth in the money supply must be kept under control. Ongoing budgetary deficits and excess governmental spending will make this difficult to accomplish.

Federal spending continues to grossly exceed tax revenues while the public continues to push for lower tax bills and refuses to reform social safety nets. Escalating expenditures including those for Medicare and Medicaid will threaten to bankrupt the nation if not confronted.

As if these budgetary items are not sufficiently problematic, a more menacing inflation enemy exists – war expenditures. According to the economic history books, this budgetary line item has been the preeminent cause of high inflation. Nothing drives inflation like war.

So, the following questions must be posed: will global conflicts escalate to the point where broad-based wars break out? Will America be able to effectively reform its heath care system in order to control costs? Will the public consent to tax increases in order to balance the budget without violent protests breaking out in the streets?

These are controversial questions, to be certain, but they are also highly relevant to the future of our currency. Rampant inflation, due to war or other causes, has previously reared its ugly head on the world scene. Hyperinflation has occurred after major wars in Germany following World War I and in Japan following World War II.

Ultimately, the investor must place a bet on inflation. Based on the projected inflation rates presented previously, it appears that the American public is in deep denial of its future. The inflation-indexed bond market is reflecting this denial, and appears to be severely underestimating future inflation. Long-term inflation in the 2-4% range seems unlikely due to the multitude of economic dilemmas at hand.

For many investors, the old proverb “hope for the best, plan for the worst” may be more germane now than ever, and TIPs may indeed be last safe haven for capital.