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

by Alexander Green, Chief Investment Strategist
Monday, May 10, 2010: Issue #1256

Two weeks ago, I wrote a column recommending Treasury Inflation-Protected Securities (TIPS) as protection against potential inflation down the road.

It prompted a flood of questions and challenges. I want to address those, but let me start by briefly re-stating my case:

1. Unprecedented government spending – including $108 trillion in unfunded liabilities for social security, Medicare and new universal healthcare benefits – is putting the nation at risk.
2. With interest rates near zero, the Federal Reserve cannot take one traditional step – lowering short-term rates – to revitalize a weakened economy.
3. In a severe economic downturn or double-dip recession, politicians – with the reluctant assistance of the Fed – could opt to spend even more massively to try to jump-start the economy.
4. The result could be stagflation: slow growth with higher inflation. (And although we haven’t seen it here in almost 30 years, perhaps even hyper-inflation.)

I don’t know what the odds of this happening are – and neither does anyone else. But I think investors would be foolish not to at least consider the possibility…

Inflation or Deflation? Hedge Your Bets This Way…

Respondents who disagreed generally fell into one of two camps…

• They either believed that deflation is more likely than inflation.
• They thought inflation was likely, but since Congress will almost certainly be the culprit, they don’t want to reward the mischief-makers by buying any kind of government securities.

Let me handle the former objection first: Is deflation more likely than inflation? Perhaps. No one can say. You should probably own a good slug of Triple-A insured municipal bonds just in case. (Because future tax rates are almost certainly going higher.)

By all means, make some plans for a deflationary scenario. But plan for the possibility of inflation, too. This is what diversification is all about. Hedge your bets.

But why use TIPS as your hedge, rather than a traditional inflation hedge like precious metals? In my view, you should use both. But remember, gold and silver are less than perfect hedges.

They have both performed exceptionally well over the last 10 years, for example. Gold has more than quadrupled. Silver has done even better. But the 20 years before that were an unmitigated disaster.

But no matter whether inflation is low or high, TIPS will protect you. How?

The Benefits of Buying Treasury Inflation-Protected Securities

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

There are three good ways to buy inflation-protected Treasuries:

1. Directly: http://www.treasurydirect.gov/indiv/research/indepth/tips/res_tips_buy.htm
2. Through the Vanguard Inflation-Protected Securities Fund (VIPSX).
3. Through its ETF equivalent – the iShares Barclays TIPS Bond Fund (NYSE: TIP).

I recommend TIPS for two primary reasons…

1. I’m not a moralist trying to claim the high ground. I’m just trying to protect myself, my family and my heirs from potentially destructive hyper-inflation. I don’t want to remain true to my free-market principles only to see the net worth I’ve accumulated over a lifetime torpedoed.
2. There is no private-sector alternative here. For good reason, private and public companies don’t want to leave themselves vulnerable to sky-high interest and principal payments down the road if inflation takes off. So they don’t issue inflation-protected securities. That makes TIPS the only game in town.

I know that some libertarians and laissez-faire capitalists will refuse to buy Treasury securities, period. But as I’ve pointed out, other inflation hedges sometimes don’t work. So there is no small risk taking another approach.

In sum, there is only one investment that guarantees a return that exceeds inflation in the years ahead: TIPS.

And in my view, that makes them an indispensable part of your portfolio.

Good investing,

Alexander Green

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by Alexander Green, Chief Investment Strategist
Monday, April 19, 2010: Issue #1241

A recent Communiqué column of mine, in which I recommended Treasury Inflation-Protected Securities (TIPS), outraged a number of readers.

Why was it so upsetting? Because – and don’t ask me what they’re smoking – 17% of Americans actually approve of the job Congress is doing.

Taking both parties to task, however, I wrote:

#1: When George W. Bush and his fellow Republicans came to power a little more than nine years ago, they promised to cut wasteful spending, limit the size of government and move closer to a balanced budget.

Instead, they…

• Created a Medicare drug entitlement that will cost nearly $1 trillion in its first decade…
• Started a string of expensive financial bailouts that continues today…
• Passed a record number of earmarks…
• Increased federal spending 58% faster than inflation…
• Presided over a $2.5 trillion increase in the public debt.

#2: Then, last November – anxious for change – voters threw the bums out and put the Democrats in charge. The Democrats promised to change this reckless course and restore fiscal sanity to the country.

Instead, they tripled the budget deficit in their first year. The White House and the Congressional Budget Office now estimate that this year’s deficit will explode to $1.56 trillion – a post-World War II record at 11% of the overall economy – and add $9.7 trillion in debt over the next decade.

Facts vs. Opinions

Here are the other points I made…

#3: The Obama Administration’s own projections see the federal debt hitting $18.5 trillion by 2020. However, that was before the passage of the healthcare reform bill – the biggest new entitlement since the creation of Medicare in 1965.

#4: Unfunded liabilities for Social Security, Medicare, Medicaid, the prescription drug benefit and the new federal healthcare program have now jumped to $108 trillion, nearly eight times our annual GDP.

#5: Moody’s has threatened to downgrade the Triple-A rating of U.S. sovereign debt, perhaps within three years. A drop in our credit rating would both decrease the perceived safety of Treasury securities and increase the interest that Uncle Sam – excuse me, you, your children and your grandchildren – will pay on the deficit.

#6: Credit Suisse recently produced a report pointing out that the country whose debt profile most resembles that of Greece is – hold your breath – the United States. (If you believe a picture is worth a thousand words, try this: http://www.usdebtclock.org/)

#7: Down the road, Washington – with the reluctant consent of the Federal Reserve – could opt to solve this problem the way so many governments throughout history have – by inflating our way out of it.

Inflation: The Bane of Debt-Holders & A Godsend to Debtors

Inflation is the bane of debt-holders, of course. But it is a godsend to debtors – and Uncle Sam is the biggest of them all – as they can repay fixed obligations with increasingly worthless currency.

What surprised me was not that some readers had a difference of opinion. I always welcome that. It was that respondents uniformly barked that they didn’t want to hear my “political opinions.”

Opinions? Go back through these seven points and tell me which one contains an opinion. Even the last one modestly states that Uncle Sam “could opt” to inflate our way out of this problem.

As Jack Nicholson reminded us in A Few Good Men, some people can’t handle the truth. Especially when it’s something they don’t want to hear.

For example…

• When we warned 11 years ago about the massive bubble in Internet stocks, the majority of respondents gushed about the New Era and insisted we “just didn’t get it.”
• When we warned six years ago about the ominous housing bubble, many scoffed and insisted that home prices “always go up.”
• When we talk today about the threat to your financial security that Washington is creating with its Ponzi-style entitlement schemes, a lot of investors don’t want to hear that, either.

Believe me, I hope I’m wrong. I don’t want high inflation any more than you do.

Fortunately, inflation today is as tame as a kitten.

The Benefits of Treasury Inflation-Protected Securities & Three Ways to Buy Them

I only suggest that you buy Treasury Inflation-Protected Securities ( TIPS) as an important insurance policy. (Because when inflation – the thief that robs us all – rears its ugly head, neither stocks nor bonds do well.)

You can purchase inflation-protected Treasuries (TIPS) in three ways…

• Directly ( http://www.treasurydirect.gov/indiv/research/indepth/tips/res_tips_buy.htm).
• Through the Vanguard Inflation-Protected Securities Fund (VIPSX).
• Through the ETF equivalent – the iShares Barclays TIPS Bond Fund (NYSE: TIP).

There are several advantages to buying TIPS…

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

Some investors complain that these securities haven’t done anything exciting lately. Of course not. We’ve been in the grip of disinflationary forces, not inflationary ones – and that won’t change next week or next month.

Protection Against The Government “Doing Something”

But as the deficit keeps expanding and the electorate grows increasingly unhappy, pressure will mount on the government to “do something.”

That “something” could be a decision to inflate our way out of this mess, rather than risk the kind of deflationary spiral that Japan has endured over the past two decades.

Bear in mind…

• The Fed has already taken interest rates close to zero…
• Congress has already tried a massive fiscal stimulus…
• The Federal Reserve has already created trillions out of thin air to mop up worthless securities.

If the economy stumbles again and further government action is taken, it could be even more reckless, resulting in inflation.

In the interest of full disclosure, however, that’s just my opinion.

Good investing,

Alexander Green

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