Wednesday, October 27, 2010

TIPS Are Not Good Inflation Hedges

TIPS - Treasury Inflation-Protected Securities - are a fairly recent type of government bond that provides the owner with interest at a rate formed by adding two factors (1) a fixed rate, and (2) an adjustable rate based on inflation.  The concept is that the total interest paid on the TIPS goes up when inflation goes up, so the TIPS are sold as inflation hedges.  The benefit to the seller (US Government) is that they can typically sell TIPS to the public at a lower price than regular bonds because the buyers figure that the payment will go up when inflation goes up and so are satisfied with a lower initial interest rate.  TIPS have become very popular, but most people don't seem to understand that they are not really getting what they think that they are buying - and that other options would most likely be better.  Below, we will discuss the downside of TIPS and what people might want to consider doing instead.

First, there are two great articles in the Wall Street Journal today that highlight the popularity of TIPS and the fact that they are misunderstood.  First, with regard to popularity, this article indicates that the sales of TIPS are expected to pass the $100Billion mark this year for the first time.  That's a lot of TIPS!

With regard to lack of understanding, TIPS are being sold as an inflation hedge - an investment with a return that will go up as inflation goes up.  They are also really in vogue with many financial planners right now who are looking for an investment to serve as an inflation hedge for their client's portfolios.  From one angle, what's not to like?  They are guaranteed by the US government and they increase part of their return with inflation, so they should be the perfect inflation hedge, right?

Not so fast!  The backing of the US government just means that payments will be made - not that the payments will actually equal the desired inflation hedge.  In fact, as this article mentions, TIPS are actually a pretty lousy inflation hedge!  In fact, the correlation was only .21!
TIPS tend to have a low "correlation" to the consumer-price index, the main inflation gauge. The correlation between the two from 2002 to 2009, for example, was just 0.21%. A correlation of 1 means two assets move in perfect lockstep, a correlation of -1 means they move in opposite directions, and a figure of zero means they are uncorrelated.
This means that people are buying TIPS expecting them to serve as an inflation hedge (with a correlation of about 1, so that TIPS and inflation move together) but instead TIPS are not actually delivering as they are being advertised because the TIPS only increase a little (about 20%) with increasing inflation.  The bottom line is - if you are looking for an inflation hedge, it isn't TIPS - regardless of what the name of the product seems to imply ("inflation protected").

The article further points out that commodities had a correlation of 0.63 over the same time period - which is far, far better than TIPS.  So if you are looking for an inflation hedge, you would be better off buying commodities.

The article also mentions, instead of TIPS, considering investing in foreign currencies based on the relative strength of the currency as compared to the US currency.  I think that that's a good idea, but it is technically more of a currency hedge than an inflation hedge.  Admittedly, though, if inflation rises in the US disproportionally to other countries (thus making the dollar worth less compared to other currencies), then this currency strategy will operate as an inflation hedge.  I would also admit that with out current and increasing level of indebtedness, our odds of higher inflation relative to other countries continues to increase.

Finally, the article mentions buying dividend-paying stocks that have operations in foreign countries.  I think that can operate as an inflation hedge, especially in a currency-based inflation environment if the company makes their profit in foreign currency and then exchanges the foreign currency for US dollars which will be worth less and less.  However, the article kind of misses the point that just buying a foreign company that makes its money in a country with a better currency return will provide the benefit - even if that company doesn't pay dividends.  The valuation of the company in dollars will substantially track the performance of the underlying currency relative to the dollar with an additional variance (up or down) based on the performance of the actual company.  An established, growing company in a foreign country with good currency policy offers the double protection of an increase in price due to the currency rising and an increase in price sue to increasing profitability.

As for specific countries, the article omits two that I would put out for your consideration - Switzerland has a very stable currency and good monetary policy that should help it remain stable as the US currency falls.  Also, China is a little more speculative, but their currency continues to rise relative to the dollar.

In summary, TIPS don't provide the inflation protection that they advertise.  If you want inflation protection, then look to commodities, foreign currencies, or foreign companies.


  1. Optimism is in very short supply these days, despite the the growing likelihood that next week's elections are going to mark a sea change for the better in the course of U.S. fiscal policy.
    US dollar inflation

  2. Parag - Interesting comment! Some may observe that optimisim may actually be large and exuberant supply if one thinks that the electons are going to change much for the better!