Accrued Interest has TIPophobia

My recent post on my aversion to TIPS resulted in a torrent of comments. OK, 10. OK, half of them were mine. OK, so we don't get a lot of comments here at Accrued Interest. Anyway...

I thought we'd do a little investment math on the subject, and really get down to it. Now, I normally try to avoid lots of formulas on this blog, because people hate to read that shit. But in real life, the math is what bonds are all about. If you follow closely to what is written below, you will see exactly why I don't buy TIPS.

Based on Bloomberg's survey, the median prediction from economists for CPI in 2007 is 2.0%. So we'll use that as a baseline. First I'll compare a 10-year TIP vs. a nominal Treasury bond. To make things easy, we'll assume that real interest rates don't change. Nominal interest rates will change based entirely on shifts in inflation. We'll run inflation as 1%, 2%, and 3%. We'll also run a 1-year horizon.

Inflation Rate = 3%: TIP 5.32%, TSY -1.88%
Inflation Rate = 2%: TIP 4.42%, TSY 4.82%
Inflation Rate = 1%: TIP 3.47%, TSY 11.89%
AVERAGE = TIP 4.40%, TSY 4.94%

So if you have equal views on inflation, the TIP is the wrong investment. But if you have even a small view that inflation is more likely to rise than fall, the TIP might make sense. In fact, the weighting to the higher inflation scenario needs to be just 38% to even the score.

Now, let's assume the Fed gets involved when inflation changes. Of course, why inflation changes is a significant question here. If energy prices are weak, and it causes CPI to print low, the Fed might not do anything. But for the sake of argument, let's assume that the Fed hikes 100bps in the 3% scenario and cuts 100bps in the 1% scenario. In both cases the effect on 10-year rates will be exactly half that of short rates. I.e., real rates shift by 50bps in addition to the inflation effect.

Inflation Rate = 3%: TIP 0.95%, TSY -5.11%
Inflation Rate = 2%: TIP 4.42%, TSY 4.82%
Inflation Rate = 1%: TIP 7.52%, TSY 15.56%
AVERAGE = TIP 4.30%, TSY 5.09%

The average difference in return is 79bps. But you only need to increase the weighting of the 3% scenario to 41% for the trade to be breakeven on average.

But we live in a world of choices. Instead of buying the 10-year Treasury by itself, what if you added a 50% position in a floating-rate bond? Again, assuming the same Fed action. We'll assume the Fed moves quarterly, the FRN resets at LIBOR flat, that LIBOR moves exactly in line with the Fed, and starts at 5.30%. Here are your returns.

Inflation Rate = 3%: TIP 0.95%, TSY/FRN 0.28%
Inflation Rate = 2%: TIP 4.42%, TSY/FRN 5.06%
Inflation Rate = 1%: TIP 7.52%, TSY/FRN 10.24%
AVERAGE = TIP 4.30%, TSY 5.20%

The breakeven probability for the 3% inflation scenario is 72%! That means that unless you view the 3% inflation scenario to be more than 72% likely, you are better off owning a combination of floaters and traditional Treasury bonds.

But wait, it gets better.

Remember that if your economic forecast is for more inflation, its entirely possible that the Fed recognizes the problem early enough to prevent any actual inflation. The result would be that rates rise, but the rate hikes mute and/or prevent any acceleration in inflation. In that case, the real rates impact on both the TIP and Treasury would be the same, but your FRN position performs extremely well.

Also, bear in mind that we've only run a 1-year scenario. Let's say that at the end of 1-year the inflation spike has resulted in several Fed hikes, but the market now figures inflation is whipped. So while you got a year's worth of extra inflation-adjustment on your TIP, when you go to sell the thing, less expected inflation is priced in, so you've suffered some price loss there. Meanwhile the TSY/FRN portfolio has performed much better, because the subsiding of inflation pressure has allowed the Treasury to appreciate (or not depreciate as much), while the floater is benefiting from higher short-term rates.

Finally, it tends to be that the curve flattens as the Fed hikes rates. The classic play on a curve flattening is to own a position in longer bonds and a position in floaters. So the TSY/FRN portfolio benefits from this tendency as well.

If you view inflation as incipient, floating-rate bonds are a good investment. They perform well whether short-term rates rise because of Fed activity or actual inflation. The weighting you give floaters in a portfolio depends on how aggressive you want to be with your inflation bet. In this piece, I gave the example of a very simple portfolio with just 10-year Treasuries and floating rate notes. In reality, you'd probably own various bonds, but you'd probably do well to make something of a barbell out of your portfolio, increasing the 10 yr+ bucket and the >1 year/FRN bucket.

Unless you have a very specific view of inflation/Fed activity which you want to play, or you have a CPI-based liability to match, I don't think TIPS are the right investment.