Thursday, June 18, 2009

Too early to turn to this TIP

Everybody is screaming about inflation and how it will destroy what little value we have left in our currency. I don't buy it. Unemployment is rising and houses are still only affordable to heavily leveraged or liquid rich guys.

But assuming we are headed for a time when housing bottoms, employment picks up, consumption upticks, and commodities prices come roaring back, are TIPS the best way to prepare ahead of time?

TIPS are treasury debt instruments sold to the public that designed to protect the buyer from problems of owning fixed income securities when inflation is eating away at yield returns. TIPS are just like treasuries, with a fixed yield for a fixed period of time. TIPS protect the owner by providing an adjusted interest payment based on the fixed rate by multiplying the inflation adjusted principal amount by the fixed interest rate. The amount of inflation adjustment is determined by semiannual adjustments (inflation adjusted principal = ((semiannual CPI + 1) * previous principal amount)). Thus as inflation adjusted principal grows, the fixed interest rate coupon paid by the TIPS security increases. (Details here)

How do you get into a TIPS position? There are two easy choices regarding buying TIPS. You can buy them individual issues directly from the Treasury at or buy the iShares Barclays TIP ETF (NYSE: TIP). Current TIPS issues track against the 10 year treasury. The TIP ETF is more attractive because it comprises of all the TIP issues outstanding. This gives a higher yield from the combination of securities than current issues sold from the Treasury. Also, with an average duration of 9.3 years to the TIPS issues held in the fund, investors will see significant protection over the next few years without siginficant volatility due to security rollovers to rebalance the fund.

Should you run out and buy TIPS now? The World Bank indicates that growth should be contracting through 2012. The world's largest container company, Maersk, indicates that the amount of containers moved has dropped tremendously due to decreases in consumer spending and that they do not expect the amount of consumer goods traffic to recover until 2015. With that perspective in mind, the threat of inflation is still a little premature and the need for protection from a security like TIPS may be muted for the next couple of years at least. But when prices start to move upward, it should be a core holding. Since CPI is a lagging indicator, there is an inherent lag in the adjustment of TIPS to the inflation incurred, giving the investor time. This advantage from the lagging indicator might be mitigated by increased demand at the TIPS auction because it is known across the market.

Ultimately, whether or not to buy TIPS depends on when you feel that inflation will become a key driver in the economy. Otherwise, in a deflationary scenario, it might be safer to stick with the paltry returns of the comparable 10-yr Treasury and enjoy the predictable yields.

To view current prices of the most recent TIPS auction results to find out what is available.

The author current does not have any position related to TIPS but expects to go long TIPS sooner rather than later.

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