Home>Video>Are TIPS as Safe as You Think?

Are TIPS as Safe as You Think?

Mon, 30 Jul 2012

Morningstar's Eric Jacobson offers a formula to gauge whether TIPS are cheap or expensive compared with other assets but also warns of potential risks should long-term yields rise.

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Video Transcript

Christine Benz: Hi, I'm Christine Benz for Morningstar. In many respects, Treasury Inflation-Protected Securities would seem to be the ideal choice for retirees, delivering a safe inflation-adjusted stream of income. But in recent years some market watchers have begun to question how safe TIPS really are? Joining me to discuss this question is Eric Jacobson. He is director of fixed-income fund research for Morningstar.

Eric, thank you so much for being here.

Eric Jacobson: Glad to be here, Christine.

Benz: Eric, let's discuss this question. TIPS yields have really gone down a lot over the past few years along with all Treasuries, and so a lot of people are asking how safe TIPS really are given how low yields are and what could happen in a prolonged period of rising interest rates. How can investors get their arms around this question? What's sort of a starting point for that analysis?

Jacobson: Well, the first thing to remember is that even though they have some wrinkles in the way that the cash flows work and the fact that you have the inflation accrual and so forth, TIPS are still bonds. And the fact of the matter is, many of them tend to be very long-maturity bonds. So, even though you have that inflation adjustment built in, which is very helpful, TIPS can and will act like long-term bonds when there are volatility swings in the marketplace. That's one of the reasons that they have done so well as regular Treasuries have done so well, and there is a fairly good risk that if we do see a spike in long-term bond yields, or worse yet, a long protracted rise in long-term bond yields, TIPS are going to feel the pain, especially longer-term maturity TIPS.

Benz: That's really not something we've seen since TIPS were originally created. We haven't had that prolonged period of rising interest rates.

Jacobson: That's exactly right. When they came out they had pretty generous real yields. Those numbers have come in dramatically over the years, and at the same time, we've had this prolonged period of falling nominal Treasury yields. So it's made TIPS look really, really good, and I think part of the risk there is that people haven't experienced that rough period, and so they don't necessarily recognize that [the risk] is out there and that it can happen.

Benz: Eric, one thing we've been hearing from people who focus on this market segment or on bonds in general is that TIPS are expensive. A question is, how does one go about making this assessment about whether TIPS are expensive or cheap at any given point in time?

Jacobson: Well, Christine, the first question that you want to ask is, what are you comparing TIPS to, and the reason for that is the common way to measure whether TIPS are expensive is to look at them relative to Treasuries, and I'll talk about that in a second. But the fact of the matter is, is that most people are really comparing them against other parts of the market as well, and you want to be careful because I can show you in a second how we might look at them and see that they're relatively cheap to Treasuries, but they could still be expensive versus other assets.

So, in terms of that measure, how do you tell? What we typically do is we pick a spot on the maturity spectrum. We look at the nominal or regular conventional Treasury bond. Then we take the yield of that bond, and we subtract the yield of the TIPS bond. That number is pretty close estimate to what they call the break-even inflation rate. Let's say, for example, it's 2%, which is the case for a lot of bonds out past the 10-year maturity point at this time. If that number is 2% then essentially what the market is telling you is that among Treasuries and TIPS there's an expectation of 2% inflation.

If inflation turns out to be lower than 2%, then you would have been better off buying the Treasury bond and holding onto it during that period of time. If inflation turns out to have been higher than 2% over that period, you are going to have done better with the TIPS because the TIP bond will have that embedded inflation accrual and it will protect you if inflation goes over 2%.

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Benz: So, when you look at that differential right now that yield differential between the nominal Treasury bond and the TIPS bond of the same maturity, what is the market saying about inflation expectations, and in turn, what can we conclude about whether TIPS are looking cheap or expensive currently?

Jacobson: Well, it's really tricky because a lot of people will argue that these numbers are artificially tweaked because of all the Federal Reserve policy pushing down nominal yields and by extension pushing down real yields. But what we're seeing in the marketplace right now is, as I mentioned, when you get out to the longer maturities, the break-even is in the 2% range, maybe a little bit above. When you go down to the very, very short maturities what you see is very, very low break-evens, in some cases down in the 1% range.

Those who follow these markets closely tend to view that as a positive sign actually for these short maturity TIPS that have very, very short durations and are really close to maturity and have these very low break-even rates because they believe that inflation is going to be above these levels. Even in our current slow-growth kind of sputtering economic situation, you are likely in many people's minds to have inflation greater than the break-even rates, which means that as long as you are not taking on really heavy long-term rate volatility risk, if you buy these short-term TIPS you are going to make out OK. It's not something I would necessarily recommend that people start trading, but it's a useful thing to understand about valuations.

Benz: Vanguard just filed [a couple of weeks ago], I believe, Eric, to launch a product that is going to focus on that very part of the TIPS market, the shorter-duration bonds. What's the calculus there? Is it the idea to maybe take advantage of the near-term opportunities, or does the company think that there is a long-term case for that sort of product?

Jacobson: Well, I think that from the institutional perspective there is probably a better understanding of the fact that negative yields don't automatically mean bad investment. So, my sense is that part of this is to get into that space and be able to compete because there are a couple of other products. PIMCO has one; iShares has one--they are both ETFs that focus on the shorter space. But I think longer-term what Vanguard is really also hoping to do is, give people an option to still buy something that has government guaranteed inflation protection without taking on the really high volatility risk that long-term bonds still carry. The firm wants to offer something to folks that want to shift down there who still insist on having that government guarantee.

Benz: Last question for you, Eric. If I'm looking at TIPS exposure for a portfolio, what are the key questions to ask, and what factors do I want to make sure are present in any TIPS investment that I choose?

Jacobson: Well, most of the TIPS portfolios out there are relatively basic. So, to the degree that they are, you want to see low costs. Both of these ETFs that I mentioned are very cheap. Most of the longer-term maturity, both ETFs and mutual funds out there, are relatively inexpensive. The exceptions tend to be like the PIMCO products, which as I sometimes say, have more bells and whistles. PIMCO can do other things, although the firm is leaning toward holding more and more TIPS right now because of its market calls. But by and large, you can buy an actively managed TIPS fund, which not a bad idea just because [such funds] can take advantage of dislocations in the market, pockets of space where there is more or less liquidity, and what have you. But a lot of people elect to go with the indexed products, and it's especially there you want to look at costs.

Benz: Eric, thank you so much for sharing your insights. We really appreciate you being here today.

Jacobson: Glad to be with you, Christine. Thank you.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.

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