Treasury Inflation-Protected Securities

Bill Gross, who runs the world’s biggest bond fund at Pimco, says in an interview with Bloomberg that the U.S. economy is stalling and a recession is a real possibility.

In another Bloomberg interview, Harvard University economics professor Martin Feldstein said he thought “there’s now a 50% chance that we could slide into a new recession.”

For investors in TIPS, talk of recession is significant, because along with its many damages a recession brings the threat of deflation.

“We’re not looking at a recession yet, but we’re at a tipping point,” Gross told Bloomberg TV. “We’re at what we call a stall speed in which corporate profits don’t grow, jobs aren’t created.”

The Fed may arrange a third round of quantitative easing, known as QE3, Gross said. That would be significant for investors in Treasury Inflation-Protected Securities, because a third round of quantitative easing would inflame inflation fears.

But Gross repeats his oft-stated criticism of U.S. Treasuries, which he calls a ‘dirty shirt’ of investments, and notes there are ‘cleaner shirts out there.’

Watch the video

More pessimism … The Associated Press hit a home run with this lead-in today on its story about the worsening economy:

Shoppers won’t shop. Companies won’t hire. The government won’t spend on economic stimulus; it’s cutting instead. And the Federal Reserve is reluctant to do anything more.

Without much to invigorate growth, the economy may be in danger of slipping into a stupor like the one Japan has failed to shake off for more than a decade. And Wall Street is spooked.

While a close-to-the-brink financial and political crisis rages, the TIP ETF today hit an all-time high, reaching $113.55 in midday trading, up about 0.6% from the previous day’s close.

This is impressive, when you consider:

• The financial crisis, in theory, involves the U.S. Treasury’s ability to pay interest and principal on Treasury Inflation-Protected Securities. Obviously, buyers of TIPS do not see this as a real threat.

• The nation’s economy is slowing:

Associated Press: The economy expanded at meager 1.3 percent annual rate in the spring after scarcely growing at all in the first three months of the year, the Commerce Department said Friday. The combined growth for the first six months of the year was the weakest since the recession ended two years ago.

• In this environment, a double-dip recession seems more likely than a spike in inflation. Fear of inflation is generally considered the driving force behind demand for TIPS. But right now, investors are looking for safety first, and the fact that TIPS provide inflation protection is a nice plus.

CNN Money: Economists say the debt ceiling debate has already damaged the U.S. economy, and many worry that a deadlock could send the country hurtling into a double-dip recession.

With a threat of default looming over U.S. Treasuries in just a few days, you might think that Treasuries would be swooning. Amazingly, they aren’t. Either investors don’t believe the threat of default is real, or they just don’t care.

To gauge how TIPS are performing, I like comparing the TIP ETF, which holds U.S. Treasury Inflation-Protected Treasuries, with two other ETFs: IEI (which holds 7-10 year traditional Treasuries) and AGG (an aggregate corporate/Treasury bond fund that is basically a ‘total bond fund’).

This is a good comparison because they all perform as ‘intermediate’ bond funds. Here are the duration numbers:

• TIP = 4.63
• IEI = 4.40
• AGG = 4.56

Here is a chart of the three over the last month.

Of the three, the TIP ETF has performed the best, with a positive gain of about .75%. The other two funds are slightly negative over the past month. As the fear of default has increased in the last two weeks, the TIP ETF has performed much better.

I don’t have a conclusion about why. But it appears are investors are seeing TIPS as a safe harbor through this crisis — certainly the view is not negative. If default actually happened, or if the U.S. lost its AAA credit rating, I’d expect these results:

• Interest rates would increase, for Treasuries, corporates, everything
• Investors would demand a higher coupon rate for TIPS
• The stock market would take a major hit
• Economic growth would take a major hit
• Deflation, not inflation, would be a threat (unless the U.S. Treasury could get approval to inflate the money supply)

Jamie Dimon, CEO of JPMorgan Chase, gave the Chamber of Commerce this opinion of the dangers of default, back in March:

If the United States actually defaults on our debt it would be catastrophic … Companies like us, every single company with Treasuries, every insurance fund, every requirement, it will start snowballing. … All short-term financing would disappear.

This wouldn’t be a positive for TIPS, or just about any other traditional U.S. investment. In fact, while TIPS mutual funds might take a hit, they would hardly be the worst of investments.

At this moment, investors don’t seem to believe any of that is likely. Hope they are right.

What I have found troubling in the last two weeks is this: Just about everyone in the government – Republicans and Democrats – agrees that the U.S. budget deficit is a serious problem. We must begin on the path to a solution. And yet our government cannot find the will to find to act. We are witnessing politics, not leadership, by both sides.

I am not sure any investment is ‘safe’ in this environment.

Bob Hinkley is known as ‘#cruncher’ on the Bogleheads forums, and rightly so. He has created and updates an incredible site with a massive amount of useful data guiding us through the history of Treasury Inflation-Protected Securities. Here’s a glimpse of part of the opening page:

All this data is a bit daunting, so I asked Bob to give me a summary of how to use the site. Here is what he wrote:

I should explain what may be the most useful part of my web site for TIPS owners who want to confirm the OID reported by TreasuryDirect or their brokers.

The Interest and OID page (e.g., TIPS INTEREST & OID FOR 2010) becomes available in November with the release of the October CPI. It can be used by those who’ve held TIPS

• For the entire year or
• From the beginning of the year until maturity or
• From the initial auction until the end of the year

For example, someone who bought the Feb 2040 at the initial auction on 2/26/2010 earned $12.59 for each $1,000 of face value for 2010.

For those who don’t meet any of the above conditions the OID can be looked up in one of the “After Market” pages. For example, assume one bought the Feb 2040 at the second auction on Aug 31, 2010. By scrolling down to the row for August 31 on 2.125% 30-YEAR TIPS DUE FEBRUARY 15, 2040 Interest and OID per $1,000 Face Value for 2010, one sees that $3.42 of OID is reportable for 2010.

The Help page (Interest & OID on After Market Purchase or Sale) explains what to do if you buy and sell a TIPS within the same year.

The site also has a page that show the monthly CPI-U going back to 1961. On the right side I’ve added 5 columns that show the annualized increase for 1, 2, 5, 10, and 30 year periods. This view of past inflation can help a TIPS investor get a feel for what the future might hold. One can change the terminal month for the annual increases by clicking on the month name at the top or bottom of the chart.

For example, I own the 10-year TIPS that matures 07/15/17. I can look down the chart, and click on the coupon rate, which is 2.625 (good old days) and find a history of interest payments and principal adjustments.

Want to look at all 10-year TIPS ever issued?

How about all the 30-years?

There is a ton of data here. Explore.