Saturday, December 15, 2007

TIPS Yielding Higher Than Other Bonds

I have long argued that if -a very big if, since I really don't think you should- you feel you must invest in U.S. government securities then you should choose the TIPS, the treasury inflation-protected security which gives you a pre-determined real yield plus compensation for inflation, and recently I pointed out how the unbelievably low yield spread between the TIPS and regular bonds provided an arbitrage opportunity. That spread is only about 2.3%:points, meaning that inflation only has to be 2.4% to make it more profitable to own TIPS and inflation has to be as low as 2.2% in order for regular bonds to be more profitable. With the historical average inflation rate being 3% and the most recent inflation number 4.3% and with the Fed doing everything it can to increase inflation further, TIPS is a certain winner compared to regular bonds.

It is a mystery why the yield spread is so low. This is a clear example of markets behaving irrationally. That people who invest in the U.S. bond market are irrational is not really new either. As pointed out in this speech by William Dulley, it has historically been the case that bond investors have underestimated future inflation. He points to studies that show that the government's cost for TIPS has been much higher than its cost for other bonds. The mirror image of the higher cost for the government is that TIPS have given investors much higher return than other bonds.

Dulley however tries to dismiss the notion that TIPS will provide higher return for investors in the future too by saying that most economists share bond investors low inflation forecasts. But since those economists didn't predict the high inflation numbers that we've seen in recent years, why should we trust them now? All this shows is how incompetent most economists are as forecasters

Another implication of this is that the TIPS-regular bond yield spread is not a reliable guide of inflationary pressures.


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