USA Best Credit Report

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Is now the time to invest into Treasury Inflation Protected Securities (TIPS)? TIPS have been an investment of much discussion of late. This report was prepared by my firm LPL Financial and discusses their views on TIPS in the current market environment.

• Higher than expected inflation readings and a slight upward revision to the Federal Reserve’s (the Fed’s) inflation forecast last week caused Treasury Inflation Protected Securities (TIPS) to come under renewed focus.
• TIPS do offer relatively cheap inflation protection as measured by the implied “break-even rate”.
• On the other hand, TIPS are still Treasuries and like all Treasuries remain expensively valued.
• TIPS are not a perfect hedge for inflation, and we employ commodities strategies in our portfolios to help provide both inflation protection and better total return opportunities
• We maintain a neutral view on TIPS and continue to believe corporate bonds offer better total return opportunities in the bond market.

TIPS outperformed conventional Treasuries last week as inflation worries crept back into the marketplace. Both the June Producer Price Index (PPI) and Consumer Price Index (CPI) releases exceeded consensus expectations. For TIPS investors, the CPI report was particularly relevant, since TIPS are tied to changes in the CPI index. The Federal Reserve also upwardly revised forecasts of inflation for both 2009 and 2010. Although the revision for 2009, up to a range of 1.3%–1.6% (from 1.0% –1.5%) for core personal consumer expenditures (PCE) was relatively minor, it nonetheless caused inflation concerns to perk up.

Market inflation expectations increased as the “break-even” inflation rate implied by TIPS rose to 1.85%, the highest level in a month. The “break-even” rate can be observed by simply subtracting the yield on 10-year TIPS from the yield on 10-year conventional Treasuries. Recall that TIPS yields are lower to begin with, since an investor’s principal amount in TIPS is adjusted monthly, presumably up, with inflation. Interest payments are also ratcheted up over time based on the higher principal amount.

Break-even Rate on TIPS Historically Low

Even at 1.85%, the break-even inflation rate implied by TIPS is low by historical standards. From this perspective, the cost to protect against inflation is relatively low on a historical basis. Another way to look at the break-even inflation rate is as follows. If inflation, as measured by the CPI index, exceeds 1.85% over 10 years (using a 10-year bond in this example), an investor is better off in a 10-year TIP rather than a 10-year conventional Treasury note. Conversely, if inflation averages less than 1.85% annually, then an investor would have been better off in a conventional Treasury. Although higher, 1.85% still represents a low hurdle rate for a long-term investor and below the 20-year CPI average of 2.9%. Therefore the cost of insuring against inflation via TIPS is relatively low.

However, the regular Treasury component of TIPS reflects the expensive valuation of the overall Treasury market. As of July 17, the 10-year TIPS traded at a yield of 1.81%, below the 2.5% historical average. A yield below the historic average is appropriate given a recovering but still weak economy; however, we would prefer a slightly higher yield in the 2.1% to 2.5% range before considering them seriously. The 10-year TIPS traded in this yield range for much of 2006 and 2007, and it better represents fair value in our view. The extra yield would also provide more protection against higher interest rates. This higher yield coupled with low break-even rates would make for a more compelling investment, but we are not there yet.

Yield of TIPS, Is it “Real”?

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The yield of Treasury Inflation Protected Securities, called a “real yield” since it is paid in addition to the built in inflation compensation, reflects the conventional Treasury aspect of TIPS and highlights that TIPS are not a perfect inflation hedge. For this reason we employ commodity exposure in our portfolios, which present both inflation protection and potentially better total return opportunities in our view. The low real yield on TIPS also suggests the sector is at a disadvantage to other fixed income sectors such as Corporate Bonds and Preferred Stocks, which offer much higher yields. Of course TIPS are AAA-rated, so there is a credit quality differential. However, we believe corporate bond and preferred stock investors are adequately compensated for risks, and we find the risk/reward profile more attractive.

TIPS enjoyed a good first half performance so far in 2009, but most of that came in March, following the Fed’s announcement significantly expanding its bond purchase program. Note that TIPS also performed well, and as designed, in May when optimism over the economy caused both rising Treasury yields and rising inflation expectations. Still TIPS underperformed corporate bonds, which returned 3.9% for the month according to the Barclays US Corporate Index, by nearly two percentage points. This coming week Fed Chairman Bernanke will provide his semi-annual testimony on monetary policy and the economy to Congress that is likely to include the first discussions of the Fed scaling back liquidity and purchase programs, which should keep inflation expectations in check.

We remain neutral on TIPS, because their relatively cheap inflation protection, as measured by the break-even rate, is offset by low yields and expensive Treasury valuations overall. We find the total return opportunities in corporate bonds and other credit sensitive bonds more compelling at this point. Commodities make a compelling alternative to help provide inflation protection. Last, as outlined in our Mid-Year Outlook, we maintain a moderate view on inflation and do not believe that a return to 1970s style inflation is forthcoming to warrant a significant exposure to TIPS over corporate bonds at this time.

IMPORTANT DISCLOSURES

• The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.
• Neither LPL Financial nor any of its affiliates make a market in the investment being discussed nor does LPL Financial or its affiliates or its officers have a financial interest in any securities of the issuer whose investment is being recommended neither LPL Financial nor its affiliates have managed or co-managed a public offering of any securities of the issuer in the past 12 months.
• Government bonds and Treasury Bills are guaranteed by the US government as to the timely payment of principal and interest and, if held to maturity, offer a fi xed rate of return and fixed principal value. However, the value of funds shares is not guaranteed and will fluctuate.
• The market value of corporate bonds will fluctuate, and if the bond is sold prior to maturity, the investor’s yield may differ from the advertised yield. Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and are subject to availability and change in price. High Yield/Junk Bonds are not investment grade securities, involve substantial risks and generally should be part of the diversifi ed portfolio of sophisticated investors.
• GNMA’s are guaranteed by the U.S. government as to the timely principal and interest, however this guarantee does not apply to the yield, nor does it protect against loss of principal if the bonds are sold prior to the payment of all underlying mortgages.
• Muni Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise. Interest income may be subject to the alternative minimum tax. Federally tax-free but other state and state and local taxes may apply.
• Investing in mutual funds involve risk, including possible loss of principal. Investments in specialized industry sectors, such as investing in commodities have additional risks, which are outlines in the prospectus.

Jeff Rose is a Certified Financial Planner and co-founder of Alliance Investment Planning Group.

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