Reader asks: Won’t rising inflation make TIPS more valuable?

Reader LDD posted a lot of great questions about TIPS, so I will share them and attempt to provide some answers:

I am new to TIPS. I have only owned some for no more than a few months in my accounts and accounts of relatives that I manage for them. … I am still trying to figure out where prices and yield of existing TIPS go in different circumstances. I just can’t find a place that shows long-term prices and yield for TIPS like they have it all over for stocks. If inflation goes up a lot, say 12% a year, the price of existing already issued TIPS should go up on the secondary market, correct? After all, they will be earning you interest on a 12% greater principal. There are 30-year TIPS you can buy on the secondary market that pay you interest right now that is about 2.5% of the price you’d pay for them. They’re the ones that mature in April of 2029 – they’re all I own as far as TIPS go. (By the way, the two brokerage firms I use do not even offer 10-year TIPS on the secondary market). If Buffett is right and in the next decade or so inflation does get as bad as in the late 70s, the value (and price on the secondary market) of existing TIPS should be going up, correct? It seems really straight forward. Which is why I don’t understand the comment by the Calafia Beach Pundit that “If you expect the economy to eke out at least some degree of growth and if you expect inflation to rise, then you had better be prepared to see TIPS prices fall (since real yields would rise), even as rising inflation improved the effective nominal yield on TIPS.” I must really be missing something, because I don’t see how rising inflation can cause a decrease of the price on my existing TIPS.

Thought one: If inflation rises to 12% in coming years — and stays there — you are going to be extremely happy that you bought those April 2029 TIPS. That is the exact reason for buying TIPS — to protect the super-safe portion of your portfolio against higher-than-expected inflation. (Not that we would be happy about 12% inflation, of course.)

Thought two: You say that you buy TIPS through a broker on the secondary market. That’s fine, and it’s the only way to buy them in a tax-deferred account. But I do suggest opening an account at TreasuryDirect.gov and begin building a ladder of TIPS there, especially if you plan to buy and hold. In 2011, there has been a TIPS auction every month of the year, some new issues and some reissues, 5-, 10- and 30-years. There are no fees for Treasury Direct. You can also buy and hold iBonds there.

Thought three: The market value of a TIPS is established by its yield to maturity. A TIPS pays a coupon rate of interest, plus the inflation adjustment. But when it goes on auction, or when you buy it on the secondary market, you pay more (or less) than the principal value. That establishes the yield to maturity.

For example, the 30-year TIPS that reissued Oct. 20 carried a coupon rate of 2.125% but auctioned at a yield to maturity of 0.999%, meaning that buyers had to pay $132.95 for $100 of this TIPS. A few months earlier, in June this same TIPS auctioned at a  yield of 1.744 and a cost of $111.69 per $100.

So the yield of this 30-year TIPS has plummeted, and the value has soared. Will that continue? It could continue, but not forever.

Thought four: What drives the TIPS yield to maturity to rise or fall? I am not confident I know, but I can say that most experts say it is: 1) the expectation of higher inflation (which makes TIPS more appealing than nominal Treasuries or bank CDs, and 2) the overall state of the economy, with the TIPS yield rising along with the national GDP.

The U.S. inflation rate for the 12 months ending in September was 3.87%, meaning that TIPS investors (and iBond buyers) did pretty well, at least compared to investors in CDs or nominal Treasuries.

The question is: Will this continue? And is that justification for these super-low yields, by far the lowest in the dozen-year history of TIPS?

The economy is going to be the key. Back in 2009, the one-year U.S. inflation rate ran negative for eight months in a row. During this time, 10-year TIPS were yielding above 2.0%, compared with about 0.195% today.

If the fear of inflation declines, the TIPS yield should increase, and the value of existing TIPS will decline. On the other hand, if inflation stays steady in the 2 to 3% range, and there is no fear of higher inflation, TIPS yields could also rise since the fear of inflation is muted.

On the economy, Scott Grannis makes the point that TIPS yields are forecasting a super-weak economy with moderate inflation (not deflation like we had in 2009.) I think that is accurate. So one factor (the economy) is holding TIPS yields down but the other factor (moderate inflation) could cause them to rise.

That is the near term. How about the longer term?

In the life of a 30-year TIPS that you buy today – and pay a premium price to get a record low yield – the economy is going to turn around. When that happens, the 30-year yield will increase to a more normal level (above 2%) and the market value of the TIPS will decline.

Inflation itself doesn’t determine the value of a TIPS — all TIPS give you the inflation adjustment. The one factor that varies is the yield to maturity — the rate that determines the price of the TIPS on the day you buy it.

When that yield rises, the TIPS value goes down. When it falls, as has been the trend for years, the value of the TIPS rises.

If you are a buy-and-hold buyer of TIPS, I still say, ‘Don’t focus on the market price.’ Build a ladder of TIPS, hold them to maturity, and then reinvest. (Many sophisticated investors disagree with me on this. Sometimes, life’s simpler when you are unsophisticated.)

If you are a buy-and-sell investor, then you need to know the risks. The price in the future may be lower. Same goes for investors in TIPS mutual funds, which have sold off a little recently but are still at historically high prices.

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