The short answer to this common fixed income question: It depends on the client. If the client’s lifestyle could be greatly affected by an unexpected spike in inflation, or if the client is generally fearful of inflation, then a higher allocation to TIPS would be warranted regardless of how “inexpensive/expensive” they appear in the market. But let’s examine this question from the wider perspective of a client who is neutral in regards to inflation protection.
First, let’s look at the market’s expectation for inflation going forward. The easiest and most effective way to determine this is to look at the break-even inflation rate, which is calculated by subtracting the yield on a TIPS bond from its nominal Treasury counterpart. For example, if a five-year TIPS bond is trading at 1.00 percent and a five-year Treasury is trading at 4.00, then the 3.00 percent difference between the two yields is roughly the market’s expectation for inflation over the next five years. The advantage of using the break-even inflation rate is it is easily observable and uses real-time, forward-looking market data. Now that we know the market’s five-year inflation expectation, we have our baseline measurement.
Traditionally, BAM’s Fixed Income Desk has not purchased nominal Treasury bonds for our client portfolios because there are better-yielding options with similar credit risk, such as U.S. agency bonds or FDIC-insured brokered CDs, and a similar break-even inflation number can be computed for these other options. For example, if evaluating the purchase of a five-year brokered CD at 5.00 percent, subtract the 1.00 percent real yield on the TIPS bond from our previous example for a break-even inflation number of 4.00 percent. Compare that number to market break-even inflation in order to make a judgment about the best product to purchase. In the example above, the break-even inflation rate on the brokered CD is 4.00 percent while the market break-even inflation rate is only 3.00 percent. Inflation would have to be 100 basis points, or 1.00 percent, higher than what the markets are currently expecting for the TIPS bond to provide the same nominal yield as the brokered CD. This same math can be applied to other fixed income securities such as U.S. agencies and taxable and tax-exempt municipal bonds. Given that large difference of 100 basis points, BAM would recommend purchasing the brokered CD as opposed to the TIPS bond.
The next logical question: What is the cutoff for when TIPS would be recommended as opposed to another nominal bond option? BAM’s rule of thumb is roughly 25 to 30 basis points. So if the difference between the break-even inflation rates is less than 25 to 30 basis points, TIPS bonds are recommended because the small yield give-up is worthwhile because of the inflation risk that is taken off the table.
When evaluating the use of TIPS, the break-even inflation rate for the nominal security and the market break-even inflation are critical. If the difference is greater than 25 to 30 basis points, then the nominal option will likely be the better solution. If the difference is less, then TIPS are the preferred solution. Remember, though, that this evaluation can vary client to client depending on sensitivity to inflation.
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