Thursday, January 26, 2006

A tip on TIPS

One of the US Treasury's key initiatives is the promotion of inflation indexed securities, TIPS for short, and after reading some of the details I can see why they are so inclined. I too would love to sell inflation indexed securities, assuming, of course, that I was the only one who produced the inflation index nor could that index, once published, ever be changed.

According to the Treasury TIPS are good that's a different ad....TIPS taste great, no they're less'll just let the Treasury tell it like they wish it was:

Benefits to Investors of a Unique Asset Class

Unique asset class (dollar-denominated, inflation-protected, full faith and credit of the United States).

* Asset for investors focused on the future real purchasing power of their savings.
* Low volatility and attractive returns.
* Higher long-run correlation with inflation than real estate, commodities, or other real assets.
* Deflation floor, i.e., won't receive back less than nominal principal value at maturity.
* Potentially increases portfolio diversification.

What makes TIPS different from normal bonds is the inflation adjusted principal upon which the coupon payments will be based. As the CPI rises, so too will the principal, although that will only be turned into hard cash at maturity. As a bonus, purchasers don't have to worry (too much) about deflation. TIPS purchaser will receive at least par value at maturity, although if the CPI starts to measure deflation than for interest calculation purposes only your principal will decline, which is what has been happening as the CPI declined the last two months.

Of the benefits noted above I found the claims of low volatility and higher long run correlation with inflation than
real estate, commodities, or other real assets difficult to swallow. Let's first touch on some of the theoretical problems and then take a look at a real world example for the empirically minded.

The first aspect of TIPS which springs to mind is the map territory problem. Inflation, the concept, refers, in many schools of thought, to the loss of purchasing power of a currency, i.e. crudely, rising prices. Inflation, the measure, is an index, compiled, by the way, by the very people who will be paying you.

That is to write, the security is not indexed to inflation, as experienced, but rather inflation as measured by the government. I can think of few things more volatile than what a group of vested individuals think about a phenomenon and what that phenomenon might actually be. I can imagine a world in which the prices of these securities become very volatile indeed.

As a theoretical matter I found the claims of TIPS higher long run correlation with inflation than the elements, the price increases of which supposedly comprise the measure, to be downright silly. As a practical matter, it can be measured.

Imagine you purchased, at auction, $100,000 of the 3-1/2% 10-Year TIPS, CUSIP #: 9128276R8, on Jan. 15, 2001. As of Feb 1, 2006, the adjusted principal amount would be $113,534 and your received coupons would total just under $19,000, the total of which is about $132,500. If you went to sell the bond the current price (thanks to a friend with a Bloomberg) is 107-10 and the auction price was 99-26 which equates to less than the inflation adjusted principal amount so to cast this in the best light let's stick with the $132,500 figure for comparison.

Imagine instead that you had bought the imaginary average house whose price change is measured by the Office of Federal Housing Enterprise Oversight for $100,000. According to their data, through Q3 2005, your house would be worth a shade under $149,000.

Imagine instead that you had purchased $100,000 of the Commodity Research Bureau's Commodity Index (which I chose to be fair, due to its inclusion of the grain complex). At last check your investment would be worth a bit above $155,000.

I won't do oil or natural gas but how about Gold and Silver. $100,000 invested in Gold or Silver on January 15, 2001 would be worth roughly $207,000 or $201,000 respectively.

In other words, the only thing that TIPS returns will have a high correlation to is the government's sense of inflation, which, thus far at least, has been much less than other "traditional" inflation hedges. But hey, I guess if you're into that kind of accuracy go ahead, buy some TIPS.

My tip on TIPS, sell them and invest the proceeds elsewhere, apparently almost anywhere..