February 22, 2008
Several astute observers of the financial scene have noticed recently that the yield on the 10-year inflation-indexed Treasury bond (a.k.a. the 10-year TIPS) has fallen to levels that look distinctly unattractive. Of course, one might ask: Unattractive compared to what?
There's no doubt that the 10-year TIPS yield has fallen sharply in recent months. As of last night's close, buying a 10-year TIPS equated with locking in a real (inflation-adjusted) yield of 1.43% for the next 10 years. Meanwhile, the always-perfect clarity of the rear-view mirror tells us that a better time to buy was last June, when the 10-year TIPS yield briefly rose to 2.83% at one point that month.
Since then, the TIPS yield has been falling virtually nonstop. Of course, the same is true for the nominal 10-year Treasury yield. Last June, the nominal 10-year was temporarily available at 5.23%, a relatively alluring yield that's since fallen to 3.77% as of yesterday.
Suffice to say, yields generally are now lower--a lot lower, in fact, compared with the prevailing rates of last June. But the decline has not been distributed evenly in the land of Treasuries. On that note, consider the chart below, which compares the yields of the 10-year TIPS with the nominal 10-year Treasury, the latter adjusted by the 12-month rolling CPI rate. (Both series are based on constant 10-year maturities using monthly data, as per the St. Louis Fed.) The result is a back-of-the-envelope attempt at putting the two Treasuries on roughly equal footing in terms of comparing real yields.
The striking feature of the chart is that inflation-adjusted yield in the nominal 10-year Treasury has sunk to an unappealing depth of roughly negative 50 basis points. In other words, adjusting the nominal 10-year yield by the latest CPI number (which reports annual inflation running at 4.3%) means that a buyer today would suffer a loss after subtracting inflation's bite.
By that standard, a 10-year TIPS yield looks pretty good. It doesn't take a Ph.D. in finance to choose a roughly real 1.5% TIPS yield over a slightly negative real yield in a nominal Treasury. Of course, if one's expecting deflation, then even a negative real yield may be a fleeting disturbance since the expected capital gain from generally falling prices may more than compensate for the current red ink in the real yield.
In any case, the current chasm in real yields won't last. As the above chart shows, sometimes the nominal Treasury offers a better deal, only to give way to superior pricing in TIPS. For the moment, the choice is clear, at least on a relative basis. Tomorrow, of course, is another day.
Indeed, it's worth reminding that the ever-changing mix of inflation and Treasury yields is forever reshuffling the opportunities, and the risks. In addition, the above chart offers clarity about the past and only the past. As such, one should consider the above chart in context with prudent forecasts of inflation and the respective yields on the nominal and inflation-indexed Treasuries, along with other asset classes too. The glitch is that no one can say for sure what's coming, although some of us aren't shy about making some educated guesses, for which all the usual caveats apply. The past, meanwhile, is forever clear and sometimes it even offers a crumb of perspective. The future, alas, is always up for grabs.
Posted by jp at February 22, 2008 10:18 AM
Is it possible to buy TIPs and short regular Treasuries?
Posted by: Anonymous at February 22, 2008 3:32 PM
TIPs may require a higher risk premium because the market perceives that the future CPI reports will be low balled.
If CPI reports were coming in the higher end than demand, TIPs would have a lower premium.
Posted by: abc at February 22, 2008 1:50 PM
"It doesn't take a Ph.D. in finance to choose a roughly real 1.5% TIPS yield over a slightly negative real yield in a nominal Treasury."
Apparently the non-Ph.D's determine market price.
Posted by: abc at February 22, 2008 1:46 PM