October 31, 2005
LET'S GET REAL
There's no mystery for the labeling of inflation-adjusted yields as real yields. Real, as any dictionary will advise, is a synonym with genuine. Thus, the real, or genuine yield one could expect to receive is deflated by the inflation rate. For those intent on acquiring nothing less there are choices in the world of government paper. In one corner are the standard Treasury issues that dispatch nominal yields and so offer no protection from a future of rising inflation. In the other, Treasury inflation-protected securities, or TIPS as they're known, which deliver a real yield that buyers secure for the life of the bond.
The question of whether to choose a real vs. nominal yield arguably requires priority status these days, courtesy of the ascending state of inflation as measured by the consumer price index. September's CPI rose by 4.7% over the previous 12 months, according to the Bureau of Labor Statistics.
With that piece of consumer price information in hand, an inquiring bond investor turns to the available yields. A topical subject given that tomorrow the FOMC meets for the first time since Ben Bernanke was nominated as Greenspan's successor. Then again, the numbers are all that really matters, and on that score the benchmark 10-year Treasury looks feeble. Indeed, the 10-year yield was 4.58% as of Friday, October 28, the Treasury Department tells us. After factoring in the 4.7% rate of CPI inflation, the 4.58% Treasury yield turns into a real yield of -0.12%. Ouch!
But all's not lost. A 10-year TIPS real yield of 2.01% is also available, the Treasury informs.
How to choose? As always, start with the facts. Fact number one: a positive real yield is always superior to a negative one. By that simple logic, the 10-year TIPS is a screaming buy relative to its nominal counterpart. Indeed, locking in a real 2% yield for the next 10 years is nothing to sneeze vs. accepting inflation-adjusted losses of 12 basis points a year, as the nominal 10-year requires of new investors at the moment.
Ah, but assumptions are necessarily embedded in such a choice. Buying the 10-year TIPS assumes that inflation is going higher still, or at least not going any lower. For those who subscribe to such a forecast, snapping up TIPS makes sense.
Then again, for those who think inflation isn't destined to go higher may still think the nominal 10-year Treasury's 4.58% isn't so bad after all. And if inflation falls, and/or the economy stumbles, the capital gains that would likely accompany a nominal Treasury's future could be substantial.
So, which scenario does the market favor? By some measures, it's tough to say. Consider the returns in two iShares ETFs that are representative of each side of the inflation debate. On the one hand, the iShares Lehman 7-10 Year Treasury (Amex: IEF) has lost 98 basis points for the four weeks through October 28, according to data from Morningstar. That's a relatively better showing next to the steeper 1.58% loss over the same period for the iShares Lehman TIPS Bond (Amex: TIP). But on a year-to-date basis through October 28, the two ETFs switch spots in this relative ranking, with the TIPS ETF gaining 99 basis points vs. a lesser 56 basis-point advance in the 7-10 Year Treasury fund. In short, clear, definitive signals as to market preference about inflation's future path are missing in action, at least in the ETF niche.
So, what's an investor to do? For starters, temporarily parking money in shorter-term Treasuries and ETF equivalents may not be a bad idea. Among the choices available: a six-month Treasury bill that yields 4.22%, or just 36 basis points below the 10-year, the Treasury reports.
Such are the options in a world of flat, or nearly flat yield curves. And with the Fed poised to elevate short-term rates by another 25 basis points at tomorrow's FOMC meeting, it pays to wait another day for buying safety.
One might reasonably wonder if Mr. Bernanke's silence can be endured in the market until Greenspan steps down on January 31. With so much riding on what the new man about the Fed will or won't do, the Treasury market may be one of the less forgiving trading realms in the coming months. Nonetheless, with a small negative real current yield in the benchmark 10-year Treasury the fixed-income set isn't worried, and that worries us.
Posted by jp at October 31, 2005 10:04 AM
But the rate they use is the rate that they say is the inflation, not necessarily the real rate, with so much being tied to COLA, they have a need to show low inflation.
Posted by: eric bloodaxe at November 1, 2005 10:16 AM
a convergence trade waiting to happen...
can I borrow a few hundred mil?
Posted by: pww214 at November 1, 2005 9:29 AM
...one of the great things about I-bonds versus Bond funds, Etf's etc. is that you don't have to be concerned with principal. Your face value is secure no matter what happens in the open market. We use them at home for our emergency "cash"; can keep them in the safe and deposit if we have too.
I admit to having used the bond market as a trade (twice in 2003 with positive effect), and if/when the long bonds get to 5.25% or so can see it again...
I just wanted to reply that I-Bonds make a terrific place to park "cash"; the rules help you not to be frivolous; and the benefits are a yield that is currently better than the 30 year...
Posted by: lotek at October 31, 2005 8:40 PM
Thank you for your blog. I've been a reader for about six months and appreciate your serious yet understandable posts.
I was especially happy to see today's post. My husband and I are trying to do a better job of investing. We are good savers but mediocre (so far) investors. I've concluded that we really couldn't do much better than Treasury bonds.
I've been looking into treasurydirect.gov and I bonds. Also now TIPS can be bought directly but noncompetitively through treasurydirect.
Posted by: Kirstie at October 31, 2005 4:49 PM