Wednesday, October 7, 2009

Do TIPs provide inflation protection...?

TIPS - Treasury Inflation Protected Bonds are designed to provide inflation protection to investors. These US government bonds have par values that increase at the rate of the CPI each year. Because the par value increases, the coupon payment also increases. Thus the payment you get is, in effect, indexed to inflation.

Jeff Opdyke of The Wall Street Journal asks - "do these bonds provide inflation protection?" Its a good question, however I think that Opdyke's analysis has some problems.

First he points to the fact that the CPI is an imperfect measure of inflation. This is absolutely true, for example the CPI doesn't include extra bag fees for airlines. But I disagree that a flaw in the index is that it doesn't include borrowing costs. The CPI specifically doesn't include borrowing costs, in part because using a cost that is directly related to inflation in the index would lead to a feedback loop. Furthermore, when mortgage rates increase, the higher borrowing costs are offset by house price appreciation - so it is unclear whether a household's costs have truly increased.

A second point raised is that if you sell the bonds before they mature, you are not guaranteed the promised return. As my students should know, this is incorrect. To earn the initial yield to maturity you need to hold bonds whose duration is equal to your holding period. Holding the bonds to their maturity exposes you to reinvestment risk from the coupons. Zvi Bodie has talked about this issue and advocates target date duration matched TIPs funds for retirement.

Finally, Opdyke argues that 3% tips would underperform 5% tips in an environment where rates increase. We have to be careful here. If the rate increase is just due to higher inflation, then there will be no difference in the real return on these bonds. But if the increase reflects a higher real rate of interest, then the lower coupon bonds will be hurt more because they have a higher duration.

Overall though, this is an interesting article and well worth a read.