A TIPS CONUNDRUM?

October 9, 2007

By the government's reckoning, inflation could hardly be less of a threat. Why, then, have inflation-indexed Treasuries performed so well in the 21st century?

TIPS, after all, are designed to thrive on higher inflation. The higher inflation goes, the better TIPS will perform. Conversely, lower inflation implies lesser performance for TIPS, in both absolute and relative terms. Meantime, if inflation's under control, doesn't that imply that the unhedged bonds paying nominal yields will do better? If not, why would anyone buy unhedged bonds if they're doomed to underperform regardless of inflation's pace?

Before you answer, let's turn to the real world track records. For the year through August, the consumer price index (CPI) rose by just 1.9%. Rarely in the past 10 years has CPI's annual pace been so low, which is to say that it's usually been higher. This has a direct bearing on TIPS for the simple reason that the bonds' principal is directly tied to the fluctuations in CPI. Higher CPIs translate into higher TIPS values, and vice versa.

Speaking of facts, inflation-indexed Treasuries have been the clear winner compared with a variety of relevant fixed-income benchmarks that are unhedged when it comes to inflation. One example can be seen in our chart below, which compares the Lehman Bros. U.S. Treasury TIPS Index to the Lehman Bros. U.S. Aggregate Bond Index, a popular measure of the domestic universe of investment-grade bonds sans inflation hedges.

As you can see, TIPS are winning the race and the triumph has been unfolding for some time. Most of the superior performance has come since 2001. For the five years through last month, the LB TIPS Index posted an annualized 5.35% total return, well above the LB Aggregate's 4.13%. TIPS also held the lead for the past five years against other indices, such as the LB Government Intermediate and LB Government Long indices.

Why have inflation-indexed bonds enjoyed a performance edge over their nominal-rate counterparts? Conceivably, there are several answers, although one in particular begs for attention, namely: one corner of the bond market expects inflation will be higher than CPI suggests.

Skeptics might argue that the TIPS market is just wrong, and that inflation is contained and in no danger of causing trouble for the foreseeable future. The official inflation numbers published by the government suggest no less. Extending this line of thinking implies that TIPS have it all wrong. But can a liquid, widely analyzed corner of the government bond market be so wrong for so long?

It's anyone's guess if TIPS will continue to lead the fixed-income pack. Without benefit of knowing next year's inflation numbers, much less next month's, we're at a loss to venture a guess. The safest route is, of course, to own TIPS and conventional bonds.

That said, we'll conclude with one question: If TIPS have so done well in recent years when inflation has been officially reported as conquered, how might inflation-indexed Treasuries fare if inflation gathers a bit more upside momentum?