Here’s a Hot “TIP” You Shouldn’t Buy

by Alexander Green, Investment U’s Chief Investment Strategist
Thursday, October 28, 2010: Issue #1376

Six months ago, I made a strong case for buying inflation-adjusted Treasuries, better known as TIPS.

I suggested that Washington’s massive fiscal stimulus, plus record-low interest rates, might ultimately prove inflationary.

So far, they haven’t. But investors clearly feel that inflation – the thief that robs us all – is just around the corner.

Look at the traditional inflation harbinger – gold. The metal has hit one new high after another this year.

TIPS (Treasury Inflation-Protected Securities) have soared, too. In fact, they’ve rallied so far that for the first time ever, five-year TIPS were sold at auction earlier this week with a yield of minus 0.5%.

That’s right… they guarantee a negative yield. Yet investors are gobbling them up anyway.

What’s going on here? Let’s start at the beginning…

The Inside Track on TIPS

Here are some Treasury Inflation-Protected Securities (TIPS) characteristics…

  • They pay interest every six months, just like a regular Treasury bond.
  • Unlike traditional bonds, your principal increases each year by the amount of inflation, as measured by the consumer price index (CPI). The semi-annual interest payments also increase by the amount of inflation.
  • The interest you receive is exempt from state and local income taxes (but not federal).
  • TIPS are less volatile than traditional bonds.
  • TIPS are excellent diversifiers.

But can TIPS possibly be worth holding, even when they sport a negative yield?

Perhaps for long-term investors (as I’ll explain in a moment). But not for short-term traders. Here’s why…

Think Twice Before Buying TIPS for the Short-Term

Current yields of less than zero on TIPS are due to rock-bottom Treasury rates and fears of higher inflation just over the horizon.

It’s simple math. Five-year Treasuries are yielding a paltry 1.2%. Given the weak dollar and Washington’s addiction to spending, traders and investors are betting that inflation will run at 1.7% or more.

That makes five-year TIPS just as attractive as five-year bonds, since 1.7% minus the 0.5% negative yield equals 1.2%.

Inflation or Disinflation?

Of course, the financial markets are a bit schizophrenic right now. Inflation protectors like gold and TIPS have rallied. But so have inflation-sensitive investments like investment grade bonds. Investors can’t seem to decide whether we’re in for inflation or disinflation.

And of course, nobody knows for sure. But TIPS have rallied by 10% over the last year, with no uptick in inflation. If the folks betting on disinflation – or its more severe cousin, outright deflation – are right, these bonds could undergo a serious price adjustment, giving investors a haircut in the process.

TIPS investors aren’t just guaranteed negative yields right now. They may also experience a negative total return for several years in a row.

So why shouldn’t long-term investors sell them outright?

How to Tackle TIPS if You’re a Long-Term or Short-Term Investor

Some would be prudent to do just that. The only catch is this: What if the inflation hawks are right?

If they are, TIPS will give a higher future return than traditional fixed-income investments – and with the highest degree of safety. (They are, after all, obligations of the U.S. government.)

True, there are other inflation alternatives. But gold has already quintupled over the last decade. And that other famous inflation hedge – your home – is likely to remain mired in quicksand for years to come, thanks to the overhang of foreclosures and other unsold properties.

The bottom line is this:

  • Long-term investors – those with a time horizon of five years or more – should hold onto their TIPS.
  • But traders and other investors with a shorter time horizon should probably give them a miss.

History shows that once an asset class turns hot – whether it’s stocks, bonds, gold, real estate or TIPS – it rarely delivers the kind of returns it did when it was heating up.

This time could be different, of course. But that’s how investors always rationalize their investments at the top.

The oldest advice is still the best: Caveat emptor.

Alexander Green