Politics & Policy

A Tip On Tips

You need to understand the real interest rate.

A fixed-income darling of the past few years has been the Treasury’s offering of securities that are indexed against inflation. The idea is that an investor can buy these bonds and get an incremental interest payment equal to the past year’s inflation rate as measured by the consumer price index. For investors who were burned by high inflation during the 1970s and early ’80s, these Treasury inflation-protected securities (TIPS) have made a lot of sense.

However, one important component of these securities is not clearly understood — the real interest rate.

The interest rate that shows up as coupons on bonds is known as the nominal, or actual, interest rate. There are two components to this interest rate: the real component and the inflation component. The real component reflects changing demands for money and will be low during times of low demand for credit, and high when the economy is booming. On the other hand, the inflation component reflects the investor expectations for inflation over the time of the bond’s existence.

Before the existence of TIPS, the real interest rate was hypothetical and was calculated by deducting the expected inflation rate from the nominal interest rate. The issuance of TIPS did away with the need to estimate the real yield since the actual yield on these TIPS would be equivalent to the real yield — since the bond was guaranteed to receive an interest payment equal to the inflation rate.

The importance of this analysis is reflected in the current risk associated with TIPS, especially the long maturities-term government bond.

As businesses have refrained from borrowing in recent years, the demand for credit has fallen, providing for a sharp decline in the real yield. Thirty-year TIPS, after peaking well above 4 percent in early 2000, have fallen to almost 2 percent recently. The current price for these bonds is 116, a 16 percent premium over their issue yield of 3 7/8 percent. So, a rise in real yields would produce a substantial loss in capital for these bonds as well, even though they are protected against inflation.

The point of this exercise is to demonstrate that TIPS, even though they have no credit risk or inflation risk, can expose conservative investors to real-interest-rate risk and substantial price volatility in the short-term.

If the economy responds to fiscal and monetary policy, a bear market in TIPS may be underway.

Tom Nugent is Executive Vice President & Chief Investment Officer of PlanMember Advisors, Inc. and an investment consultant for Wealth Management Services of South Carolina.

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