Do TIPS really keep up with real inflation? The most important thing to remember is that TIPS provide a guaranteed real return. While this might be a bit complex, here are two ways TIPS can provide you with a guaranteed real return, which I will outline below. In addition, I have included relevant information about real returns versus nominal returns, and individual inflation rate versus the CPI as it pertains to TIPS.
First, the return cannot be less than the real yield to maturity (YTM) at the time of purchase. Remember though that there is a difference between the coupon and the yield to maturity. If you buy a TIPS with a 2% coupon and pay above par the YTM will be less than the coupon (if you pay below par, the YTM will be more than the coupon).
You also need to understand that the inflation factor is not paid in the form of interest. Instead, it is added to the principal, this adjustment is called the inflation factor. If you have a positive CPI, the inflation factor rises (and falls with a negative CPI). Thus, it is possible that you can buy a TIPS with an inflation factor of say 110 and have that inflation factor fall, reducing your NOMINAL (but not real) return.
Second, TIPS have a unique feature that is very valuable: they cannot mature at less than par (100). That means that if you purchased a TIPS with an inflation factor of 110 and from that point until maturity the inflation factor was a negative 20%, the TIPS would not mature at 90, but 100. Thus the real cumulative return would be greater than the YTM at the time of purchase, with the difference being that 10% cumulative deflation in excess of the inflation factor.
It is very important that investors understand that the only returns that really matter are REAL returns, as you cannot spend nominal dollars. Unfortunately, many people are fooled by what I call the “money illusion.” Consider the following simple example. Which return would you rather earn:
The 10% nominal return is actually a negative return of 2% in terms of spending power, while the 0% return is actually a 5% positive return in terms of spending power. Making it even worse is that you pay taxes on the “phantom” (nominal) income. So in the example of the 10% nominal return and you are in a 30% tax bracket you only earned 7%, or a real return of negative 5%. The lesson is to focus on the REAL return you earn and ignore the nominal return.
Another thing to consider is your inflation rate versus the CPI. Some people’s individual inflation rate will be above average and some below. It cannot be that everyone’s inflation rate is above average. For example, if it is housing prices rising rapidly that is driving the CPI up, then those that own homes already will have a lower than average inflation rate. If it is food prices, then those that spend a high percentage of their income on food will have a higher than average inflation rate. It just depends.
Unfortunately, there really is no good way to hedge your unique inflation rate. Your choices still come down to nominal bonds or real bonds, or taking the risk of owning equities. And equities are not a good inflation hedge despite the conventional wisdom. Stocks are far too volatile to hedge inflation. For example, in 2007 stocks fell dramatically but inflation rose. In fact there is a negative correlation between stock returns and inflation, and the longer the horizon, the more negative it becomes (at least out to five years). Stocks have expected returns that are higher than inflation because they are risky assets. But don’t mix the two issues up, a common error. And also note that investments in commodities (e.g., futures contracts) are also too volatile to hedge inflation.
Besides TIPS, there is one other way to hedge the risk of unexpected inflation and that is to have a fixed rate long-term mortgage. If we experienced unexpected inflation interest rates would rise but your mortgage payment would remain fixed. The result is that in real terms the payments would be falling.
If you are interested in learning more about TIPS I recommend you read either my new book The Only Guide to Alternative Investments You’ll Ever Need (which has a chapter on TIPS) or The Only Guide to a Winning Bond Strategy You’ll Ever Need, which also covers TIPS.
Disclaimer: Mr. Swedroe’s opinions and comments expressed are his own, and may not accurately reflect those of the firm, nor Moolanomy and its owner.
Reviewed and Updated October 18, 2011