Academics Rave About TIPS Bonds
The U.S. stock market’s double-digit annual returns can’t go on forever, financial economists meeting at UCLA last weekend universally agreed.
But rather than try to predict when the party will end, many of the economists had another idea: Stock investors should hedge their bets with a security that offers a guaranteed return: inflation-indexed U.S. government bonds known as TIPS, or Treasury Inflation-Protection Securities.
TIPS “are the deal of the century,” said Michael Brennan, a finance professor at both the London Business School and UCLA’s Anderson School.
The UCLA conference focused on the “equity premium,” or the amount by which stocks have outperformed bonds over time.
While stock returns have trounced bonds in recent years, the academics believe the normal premium is far lower.
If the upshot, then, is that bonds may be a better deal going forward, relatively speaking, the academics said TIPS may be a particularly good deal.
TIPS, available in maturities of five, 10 and 30 years, currently pay annualized yields ranging from about 3.7% to 3.88%.
That appears to be less than what regular Treasury securities pay. But those TIPS yields are guaranteed “real” yields. In other words, you’re assured of earning those yields above and beyond whatever the inflation rate happens to be.
With conventional bonds, by contrast, there is no way of knowing what the real, after-inflation return will be over time. Because bond yields are fixed, any rise in inflation reduces your real return.
TIPS bonds work by indexing the underlying principal for inflation. The Treasury makes up for any inflation by paying you for it when the bonds mature.
TIPS “are incredibly cheap insurance . . . to protect your purchasing power in retirement” said Jay Ritter of the University of Florida.
The market’s long-term expectation for inflation is easily calculated by subtracting TIPS’ yields from regular Treasury yields. Today, that works out to an inflation rate of about 1.5%.
The economists meeting at UCLA argued that that may be unrealistically low. If inflation is higher, the TIPS will be a a better deal long-term than regular Treasuries.
In the current market, about the only risk TIPS investors face is the unlikely scenario that inflation will simply stabilize under 1% per year. And even then, returns on today’s TIPS would only lag regular Treasuries’ returns by about one percentage point, annualized.
More likely, at current yields, “the inflation-protection is free,” Ritter said.
So far, the Treasury has only sold a relative few TIPS--about $78 billion worth, in all.
TIPS have not been very popular since they were first issued in January, 1997, and only a fraction have been purchased by individual investors. They are available directly from the Treasury (for information: 202-874-4000), but are issued infrequently.
A broker is needed to buy TIPS already in the market. A broker also is needed to put these in a tax-deferred account (such as an IRA), which many experts advise. Why? Because the inflation-protection adjustment is made--and is taxable--annually, but isn’t formally paid until the bonds mature.
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Daniel Gaines can be reached at daniel.gaines@latimes.com.
