Reading Between the Lines - The Spread Between Treasuries and TIPs

Whether you occasionally read the Wall Street Journal or are a regular watcher of CNBC, you no doubt often hear money managers, bankers, and executives discussing their outlook forinflation. Anyone who lived through the 1970’s knows why this is important for everyone from your house to the White House – when real wage growth isn’t able to keep pace with constant increases in the price of basic goods and services, the quality of life, both financially and emotionally, can decrease substantially as the average citizens attempts to adjust.

Thanks in part to the work of Nobel Prize winning economist Milton Friedman the Federal Reserve now recognizes this phenomenon as an incendiary tax that consumes the nation’s wealth and, beginning with the courageous decision of former Fed Chairman Paul Volker to take, as Warren Buffett once called it, “a 2x4” to the back of inflation,” the wise policies of Alan Greenspan, and now Ben Bernanke, the United States has enjoyed an extraordinarily long stretch of low-inflation coupled with high-growth. This, in part, was responsible for the 700% rise in per-capita GDP while the average hours worked fell from around 51 to 37 between 1900 and 2006. Not to mention that even small things - cars that, adjusted for inflation cost the same amount as they did thirty years ago, now have heated seats, navigation systems, air condition, and more.

A Basic Primer on TIPs Bonds

Short for Treasury Inflation Protection Security, TIPs are very much like regular Treasury bonds except that the principal value of the bond upon redemption is indexed for inflation as measured by changes in the Consumer Price Index, or CPI. The coupon rate, expressed as a percentage of the bond’s value, is constant but fluctuates based on the underlying change in the maturity value.

Here’s a simple illustration: Imagine you bought a 10 year TIP bond with a par value of $10,000 and a coupon rate of 2.5%. Your interest is payable on a semi-annual basis, meaning that in the first year, you will receive two payments of $125 each ($250 per year which is 2.5% of the par value $10,000 bond.) Now, imagine that the CPI increases the following year by 3.5%. The maturity value of your bond will increase to $10,350 – that is the amount, in other words, you will receive when it matures and the government sends you a check (or deposits the money into a bank account, as it were) to repay the money you lent it. Now, the payment you receive will be based upon that new value – that is, $258.75 annually, or $129.38 semi-annually. Theoretically, in real terms you are no better off – you can still buy the same amount of hamburgers, laundry detergent, coffee, etc.

On a side note, one criticism is that TIPs are taxed exactly like regular Treasury bonds, meaning that if your income and the maturity value of your bond increased as a result of a rise in the CPI, you would pay taxes on that increase just as you would any other capital gain. The result is that the bondholder is still behind the inflation 8-ball, but are nevertheless ahead of where they would have otherwise been holding regular Treasuries.

The Relationship Between TIPs Spreads and Inflation

For example, on January 18, 2007, the 10-Year Treasury yielded 4.749% while the 10-Year TIP 2.47%, leaving a spread of 2.279%. Professional money managers refer to this difference between regular Treasury bonds and the related TIPs as the “implied breakeven point.” In practical terms, it means that if you believe inflation will exceed 2.279%, you would be better off financially holding TIPs than regular Treasury bills, notes, and bonds. If, on the other hand, you think inflation will fall, you will do better with the plain vanilla fare.

Although the work of the Federal Reserve is easily understood, their decision on interest rates in any one period is anyone’s guess. In theory, bond traders and analysts will look at this spread and attempt to use it to determine whether the Fed will raise, lower, or hold steady the Discount Rate which, in turn, will influence the Fed Funds Rate and the rate of all interest rates in the economy. The bigger the threat of inflation, the bigger the spread, and therefore, the thinking goes, the more likely interest rates will rise. This will, in turn, cause bond prices to fall. In such a scenario, an investor might conceivably cut his or her bond holdings, instead sitting on the sidelines with cash, short-term TIPs, or equities depending upon the situation. Likewise, if the spread was extremely narrow, it might be reasonable to think rates would fall, bond prices would increase generating capital gains for their owners, and they would pile intofixed income investments in anticipation of that movement.