Thursday, February 3, 2011

The low real return on inflation linked bonds.

Jeremy Siegel discusses the near zero (and in some cases negative) real return on TIPs and what this means for investors. (source: Financial Times)

First, a bit of background:

  • Siegel is a Wharton Professor who is famous (in the finance world) for his book "Stocks for the long run".  Siegel is a strong believer in stocks being excellent long run inflation hedges.  
  • TIPs are inflation linked bonds that earn a real return plus the rate of inflation.  The inflation return is certain - the uncertain part is the real return that you earn.

OK, back to the article.  Siegel argues that the low real return on TIPs is due to the low level of economic growth.  This makes sense because it is broadly the case that the real rate of interest should roughly equate to the real growth rate.  He argues that as the economy improves, real growth will increase and so will the yield on TIPs.  Of course, as any student of bond math knows, an increase in rates will result in a drop in the price of the bond.   Siegel argues that the drop in the price of TIPs is all but inevitable as the economy improves.  His solution is to sell TIPs and buy stocks.

His argument has merits, but moving from TIPs to equities will substantially increase the risk of a portfolio.  So while you might dodge an as yet uncertain rate increase on TIPs, you'll expose yourself to much greater market risk.  Furthermore, other fixed income securities would come off worse than TIPs as they would be negatively impacted by both real rate increases and inflation rate increases.