Over the past few months, a number of clients have asked why we have not purchased any Treasury Inflation Protected Securities (“TIPS”) in their portfolio.  The reason is we thought they were too expensive.

Before we get too deep into this subject, let us take a moment to explain what a TIP is?  A TIP is a longer-term bond where the principal value increases with inflation or decreases with deflation using the Consumer Price Index as its guide.  Like other Treasury Bonds, interest is paid twice a year.  Unlike other Treasury Bonds, the interest payment is made on the adjusted principal so interest payments rise with inflation and fall with deflation.  With all the talk of coming inflation, many investors have been sold a TIP based on the premise that it is a safe investment.  Those same investors were likely shocked to see that TIPS have been down more than 10% since April!

General speaking, there are two circumstances under which TIPS will lose value.  Presently, both of them exist.  The first is the existence of a deflationary time period or an expectation of a deflationary time period.  During such a time, the principal and interest payments of a TIP will drop in value.  Although we are technically not in a deflationary time period looking solely at the movement of the Consumer Price Index, the talk of “tapering” the Federal Reserves’ purchases of mortgage backed bonds has caused consumer sentiment to lean toward deflation.

The second and most prevalent reason for a loss of value in TIPS today is the price an investor pays for TIPs “protection”.  In other words, TIPS have been grossly overpriced as TIP real yields have been negative since January of 2012.  This means that since January 2012, investors were actually paying the U.S. Government to protect their principal.  On June 10th, 2013, U.S. 10-yr TIP yields traded above 0 for the first time since January 2012.

Future thoughts

Do we like TIPS now?  No, we do not.  As the last few months have shown, TIPS trade like other long-term Treasury bonds and we believe that the “real yield” is still below what an investor should accept, given the risk.  Does this mean they will continue to go down in value?  Not necessarily.  If inflation picks up and/or interest rates fall – i.e., a financial shock from Europe, TIPS could appreciate in value.  However, we believe we are not getting paid enough for the downside risk that TIPS present at this time.  In the late 1990’s, real yields for the Barclay’s U.S. TIPS Index reached 4% and it was a great time to invest.  If we can get TIPS at the right price, we certainly will consider them for the fixed income portion of our clients’ portfolios.  Keep in mind our point earlier – TIPS trade like long-term Treasury bonds.  Our decision to shorten the average maturity in our fixed income assets has proven to be correct over the past few weeks and has lessened the impact of this bond market decline.  If we have a change in our investment analysis of this part of the bond market, we will definitely keep you informed.

Sincerely,

Your THOR Team