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Is Inflation on the Horizon?  Here is What You Can Do Thumbnail

Is Inflation on the Horizon? Here is What You Can Do

“Dame Fortune is a fickle gipsy, and always blind, and often tipsy.”

-Winthrop Mackworth Praed, 19th Century British Poet/Politician

 

Editor’s note:  On Friday (March 14) the Wall Street Journal ran the headline on page B1, “Investors Fear Inflation Impact on Dollar Rally”, one of a number of headlines and articles mentioning inflation in recent days.  There undoubtedly will be more.  That said, it has been four years since we published this piece on inflation-protected securities, a neglected corner of the market that is also heating up now.   It is apropos that we repeat it here (with updated numbers) for new and old readers alike.

Unless you have salt and pepper hair (okay, in truth, mostly salt!), you have no memory of a time when inflation was a “problem”.   Very few people left on Wall Street or in the financial media can remember when the BLS’s (Bureau of Labor Statistics) quarterly pronouncements on inflation were the most anticipated and feared of government data releases.  Their amnesia is not without reason.  In the past 39 years there have only been a dozen quarters when inflation has exceeded 2% per annum and only twice has it surpassed 4% (once in 1987 and once in 2007).   In fact, especially for those in Europe and Japan, deflation has been the more fearsome specter.  This is why last month’s announcement that the Producer Price Index (PPI), a measure of inflation at the wholesale level, notched its biggest gain in four years passed largely unnoticed.  If every journey begins with a single step, every macroeconomic trend begins with a single data point!  But it is way too early to tell if we are in the nascent stages of a surge in inflation.   The Cassandras have been mostly wrong for years now, so claiming inflation is nigh makes one sound like the boy crying wolf.  In 2011, after a similar quarterly uptick and in the early stages of “QE” (quantitative easing) many economists (especially those old enough to remember the aforementioned 1970s/early 80s) sounded ominous alarms about significant inflation that never materialized.

If you do suspect inflation over the horizon, what can you do about it?  Studies show that there are very few effective hedges against inflation (even among commodities, which the conventional wisdom often holds do the trick), but that is not the focus of this note.  Let’s take a look at TIPS (Treasury Inflation-Protected Securities).  TIPS were introduced by the Treasury in 1997.  They are U.S. Government Bonds that immunize interest and principal against increases in inflation.  Here is how they work.  Consider a 10-year TIPS ($1000 notional) with a 2% coupon.  Each six months the principal is adjusted for inflation and the 1% semi-annual coupon is applied to this new principal.  At maturity, the fully adjusted principal is paid to the investor.  For example, if after six months inflation is 3% (not annualized), then the principal of the bond becomes $1030 and the coupon will be $10.30.  If after 10 years, cumulative inflation has been 28%, the principal redeemed will be $1280.  If there is deflation in any period, the principal can drop, but can never go below the initial $1000 (essentially the investor has an embedded option against net deflation).

An example of an actual TIPS was a 10-year bond issued in January 1999 with a 3.875% coupon.  The bond returned $447.43 in cumulative coupon payments (vs. $387.50 “unadjusted”) and redeemed $1310 principal at maturity, reflecting total inflation over the decade of 31%, or about 2.7% per annum.  The ordinary 10-year Treasury issued in January 1999 had a 4.75% coupon, so returned $475 in cumulative interest and, of course, $1000 in principal at maturity.  Clearly the TIPS was superior in this case.

The coupon on a TIPS naturally trades at a discount to the same-maturity ordinary Treasury, the difference providing some insight into inflation expectations and allowing the calculation of a “breakeven” inflation rate that would make both securities have the same payoff.  For example, suppose you had a one-year Treasury at par (100) with a 5% coupon and a one-year TIPS at par with a 2% coupon (assume, for simplicity, annual as opposed to actual semi-annual, coupon payment).   The Treasury will redeem 105 in one year.  For the TIPS to be equivalent, inflation must be 2.94%:  (2%)*(102.94) + 102.94 = 105.

Currently, the ordinary 10-year Treasury yield is 1.71% and the 10-year TIPS yield is –0.56%.  The breakeven inflation rate in this case is about 2.30% per annum, the highest it has been since 2012, when Quantitative Easing last stoked inflation fears. If inflation averages more than 2.30% over the next decade, the TIPS will outperform the straight 10-year bond.  That’s food for thought, especially for us graybeards.  No doubt Dame Fortune is fickle, but methinks my portfolio should be a bit TIPSy!

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