Because the rate of inflation has a significant impact on the financial markets, the ability to project or anticipate inflation rates is of substantial importance to investors and market analysts. Popular instruments used to help investors forecast inflation rates are Treasury inflation protected securities[1] (TIPS) and the TIPS yield spread.
What Are TIPS?
TIPS are U.S. Treasury securities that are indexed to inflation, a strategic design that helps protect investors from inflation costs and other negative effects. TIPS are given backing by the U.S. government, thus they are generally considered extremely low-risk investments. The par values of these securities rise and fall with inflation, as measured by the consumer price index[2] (CPI), while their interest rates remain the same (often referred to as a fixed interest rate). TIPS can be purchased from the government directly through TreasuryDirect, or obtained through the services of a bank, brokerage firm or dealer. These securities are available with a minimum $100 investment and can be purchased in five-, 10- and 30-year maturities. The cost for TIPS that are directly purchased may include a discount or a premium, as well as accrued interest. The Internal Revenue Service (IRS) considers the semiannual inflation adjustments on TIPS bonds to be taxable income, so many investors choose to gain access to TIPS through mutual funds or exchange-traded funds[3] (ETFs), or to hold them in tax-deferred retirement accounts. Still, the direct purchase of TIPS enables an investor to avoid state and local taxes, and the management fees that are attached to mutual funds.
Measuring Inflation: the TIPS Spread Yield
Inflation expectation measurements are of great importance, not only for investors, but also for the credibility and efficacy of monetary policy. Determining inflation expectation is often possible by looking at the differences in yield between TIPS (otherwise known as real Treasury yields) and traditional Treasury securities (otherwise referred to as nominal Treasury security yields) of the same maturity. The resulting yield difference is an indication of a breakeven point[4] inflation rate, an inflation level at which both types of securities become profitable for their given maturity. Real and nominal Treasury securities have differing yields, despite the same maturity date, because payment for TIPS track with inflation, while payments for nominal Treasury securities do not.
The Importance of Predicting Inflation Rates
The most important aspect of comparing and measuring the difference in yields between these two types of Treasury securities is the ability to somewhat accurately measure the market's expectation of the future inflation[5] rates as measured by the CPI. In a basic sense, a traditional Treasury bond's yield-to-maturity pays the holder a fixed nominal coupon. The principal compensates the investor for inflation in the future. The TIPS, the coupons and the principals track with the CPI, thus this security's yield only includes the real rate of interest. Therefore, measuring the difference between these two types of securities indicates inflation over the securities' maturity horizon. A larger spread between the two yields is an indication of higher investor expectations. Conversely, a smaller spread indicates lower investor expectations. For an investor, it becomes important to watch the TIPS spread yield, specifically when the spread is larger or is in the process of widening. As an example of forecasting inflation using the TIPS yield spread, assume that the five-year Treasury has a yield of 4% and the five-year TIPS has yield of 2%. This would indicate that inflation expectations for the next five years are approximately 2% per year. Essentially, a wider TIPS spread indicates higher inflation, while a narrower spread indicates lower inflation rates.
As to how well the TIPS spread has performed in forecasting inflation, its track record since 1997 indicates that, about two-thirds of the time, using the TIPS spread has resulted in underestimating inflation. Still, the TIPS spread is generally relied on to provide at least a reasonable inflation estimate.
For Investors Interested in Investing in TIPS
As previously mentioned, investors may wish to directly purchase TIPS. However, investors may also explore the option of TIPS through the use of ETFs or mutual funds. Options for investing either directly or indirectly in TIPS are numerous, and the choice depends largely on the specific investment interests of the investor. Some examples of available TIPS investment vehicles include the iShares Barclays TIPS Bond Fund ETF (NYSEARCA: TIP[6]), the American Beacon Treasury Inflation Protected Securities Fund ("ATPIX"), and the SPDR Barclays Capital TIPS Fund ETF (NYSEARCA: IPE[7]).
References
- ^ Treasury inflation protected securities (www.investopedia.com)
- ^ consumer price index (www.investopedia.com)
- ^ exchange-traded funds (www.investopedia.com)
- < a href="#readabilityLink-4" title="Jump to Link in Article">^ breakeven point (www.investopedia.com)
- ^ inflation (www.investopedia.com)
- ^ TIP (www.investopedia.com)
- ^ IPE (www.investopedia.com)
Source → Using the TIPS Spread to Predict Inflation (TIP, ATPIX)
