Comparing TIPS To Nominal BondsAdvisor Perspectives
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This article originally appeared on ETF.COM here.
I’ve been getting lots of questions lately about the merits of owning Treasury inflation-protected securities (TIPS] versus nominal bonds. With that in mind, today I’ll discuss how to determine the more appropriate strategy.
To begin, we need to recognize there are two ways one can hold TIPS and nominal bonds: purchase the bonds individually or invest in mutual funds/ETFs. When investing through taxable accounts and IRAs, one can do either. However, in corporate retirement plans, such as a 401(k), one is limited to funds.
Comparing five-year maturities
To keep the analysis simple, and because my firm, Buckingham Strategic Wealth, generally recommends building bond portfolios with an average maturity of about five years, I’ll analyze TIPS and nominal Treasuries with five-year maturities. (The same analysis can be done for other maturities.) As of this writing, Aug, 14, 2018, the five-year TIPS was yielding 0.77% and the five-year nominal Treasury was yielding 2.76%. Thus, the breakeven inflation rate was 1.99%. That doesn’t mean, however, the market is estimating future inflation of 1.99%.
There are two reasons why you cannot make this assumption about inflation. The first is that nominal Treasury bonds are the most liquid market in the world. While TIPS are relatively liquid securities, and also carry the full faith and credit of the U.S. government, they are not as liquid as nominal bonds. Investors in nominal Treasuries pay a premium (in the form of a lower yield) to own them. The second is that the yield on nominal Treasuries has three, not two, components: the real yield, the expected rate of inflation and a risk premium for unexpected inflation. TIPS yields are determined only by the real yield.
The TIPS-to-nominal-yield spread
Observe that the liquidity premium (which depresses yields) and the risk premium for unexpected inflation (which increases yields) work in opposite directions and may cancel each other out. If that is the case, then the TIPS-to-nominal-bond spread is a good indicator of the market’s aggregate view of expected inflation.
To obtain an estimate of expected inflation, we might use the Federal Reserve Bank of Philadelphia’s Survey of Professional Forecasters. This survey is the oldest quarterly survey of macroeconomic forecasts in the U.S. It began in 1968 and was first conducted by the American Statistical Association and the National Bureau of Economic Research. The Federal Reserve Bank of Philadelphia took over the survey in 1990. Those making forecasts include more than 50 economists from many of the leading financial and research institutions in the country. Their views help shape opinions about expectations for inflation.
Read the full article here by Larry Swedroe, Advisor Perspectives