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TIPS, Inflation and Your Portfolio

Inflation is a fixed-income portfolio's silent enemy. Someone who invests $10,000 in 10-year treasury bonds with a five percent coupon per year receives two payments of $250 per year throughout the maturity of the bond. Unfortunately, inflation can quietly erode the real value of those fixed interest payments.

What if there was a way to make fixed-income less fixed? Treasury inflation-protected securities (TIPS) do just that: they adjust an investor's principal to keep pace with the Consumer Price Index, a common inflation indicator, and investors earn interest on that inflation-adjusted principal.

Conceptually, TIPS yields should equal the real interest rate, which is the nominal interest rate minus the inflation rate, or, simply, a similar unprotected Treasury's yield minus the inflation rate. This relationship between Treasury and TIPS yields could help investors gauge the market's expectation of inflation.

Over the course of their seven-year existence, TIPS yielded, on average, 25 basis points per year more than they should have given the measured rate of inflation. The following table shows 10-year TIPS and Treasury yields, the implied inflation as determined by the spread in their yields, the measured inflation rate, and an error column that shows the difference between the implied and measured inflation rates.

Date 10-Year TIPS Yield (%) 10-Year Treasury Yield (%) Implied Inflation (%) Measured Inflation (%) Error
3/18/04 1.326 3.713 2.387 1.031 1.356
12/31/03 1.953 4.218 2.265 1.879 0.386
12/31/02 2.226 3.743 1.517 2.377 -0.860
12/31/01 3.546 5.056 1.510 1.552 -0.042
12/29/00 3.731 5.186 1.455 3.387 -1.932
12/31/99 4.326 6.485 2.159 2.685 -0.526
12/31/98 3.846 4.681 0.835 1.612 -0.777
12/31/97 3.705 5.787 2.082 1.702 0.380

Over the past two years, TIPS yields reflected a higher implied inflation rate than was measured. Investors inclined to use the spreads between Treasury and TIPS yields to predict future inflation would say that the market believes inflation will rise in the future. Historically, however, spreads between Treasury and TIPS yields were very inaccurate predictors of even just the direction of future inflation.

If an investor interprets the error column in the table above as a measure of the market's bias toward higher or lower future inflation, he or she would be led in the wrong direction in five of the TIPS' seven-year existence. The following table shows the predictions based on the error column, and whether each prediction was correct or incorrect in predicting the direction of the following year's inflation rate.

Date Implied Inflation (%) Measured Inflation (%) Inflation Prediction Correct Prediction?
3/18/04 2.387 1.031 HIGHER ?
12/31/03 2.265 1.879 HIGHER Incorrect
12/31/02 1.517 2.377 Lower CORRECT
12/31/01 1.510 1.552 Lower Incorrect
12/29/00 1.455 3.387 Lower CORRECT
12/31/99 2.159 2.685 Lower Incorrect
12/31/98 0.835 1.612 Lower Incorrect
12/31/97 2.082 1.702 HIGHER Incorrect

Of course, some may just write off this poor track record of using TIPS to predict future inflation to a number of factors, including the relatively undeveloped nature of the TIPS market. In the future, as the market for TIPS grows, perhaps it will become more useful for predicting inflation. In the meantime, however, they serve a valuable purpose in investor's portfolios.

In the long run, small favorable or unfavorable TIPS yields likely won't mean much to an investor's portfolio. TIPS will really earn their stripes in sustainable, highly troublesome periods of inflation like during the late 1970's and early 1980's. And with all economic signs pointing to higher inflation (e.g. economic expansion, astronomical commodity prices, the falling value of the dollar, etc.), TIPS should be at least a small part of your fixed-income portfolio.

Note: This article appeared in the March 24, 2004 edition of The Daily Record, a law and business newspaper published in Rochester, New York.