Much has been written of late extolling what many perceive to be the unparalleled virtues of Treasury Inflation Protected Securities, often referred to as TIPS. The U.S. Treasury issues TIPS, typically in ten-year maturities. Because they are Treasury-issued securities, repayment is backed by the full faith and credit of the federal government.

What differentiates them from other Treasury securities is that the principal value of TIPS is periodically adjusted for inflation, as measured by the Consumer Price Index or CPI. A fixed interest rate is paid on the adjusted amount. At maturity, if inflation has increased the value of the principal, the investor receives the higher value. If deflation has decreased the value, the investor still receives the original face amount of the security.

Sounds like a good deal? Perhaps.

We believe TIPS are attractive from a long-term, strategic point of view, given the expected change in secular inflation trends. However, from a tactical standpoint, TIPS are currently richly priced, as measured by very high breakeven rates. (Breakeven rates are the difference in yield between TIPS and nominal, or traditional, Treasuries. If inflation rises above the breakeven rate, then an investor earns a better return by holding TIPS. If inflation rises less than the breakeven rate, then an investor is better off in nominals.) With our forecast for continued low inflation and the expectation that oil prices may decline, we believe it is too early to establish large positions in inflation-protected securities.

A Strong 2003

Inflation expectations began to build in the market, due to the large amounts of both fiscal and monetary stimuli. Yet, judging by the actual results displayed in the inflation chart, to date bondholders had little to fear from inflation. Still, the yield curve was very steep, traditionally signaling a stronger economy ahead and higher inflation. As investors began to look for ways to protect their fixed-income portfolios from a potential rise in inflation, TIPS became a viable option-they have now been around since 1997, giving investors a track record to analyze. At just $223 billion, however, the market is relatively small compared with other fixed-income sectors; the rise in demand may have overwhelmed available supply, bidding up prices and boosting overall total returns.

Too Early, Too Expensive

Given our forecast for inflation to remain very low both this year and next, we believe there are better total return opportunities available in other sectors of the fixed-income market at this time. Further support for our argument can be found by looking at the close relationship between the breakeven rate on TIPS and the price of crude oil. Research shows a 0.62 correlation between the two. If oil prices fall and inflation remains low, as we anticipate, then TIP returns are likely to be disappointing. The securities could cheapen, providing a better entry point.

Another consideration is the growth in Treasury financing needs from the federal budget deficit. With their low coupons, issuing TIPS is a cheap source of funding. Increased supply might move supply and demand into better balance, easing upward pressure on valuations. At the same time, inflation fears may ease when the Federal Reserve begins to hike rates. The demand for TIPS may fade as the yield curve flattens. From a tactical perspective, we believe we may have a better opportunity later to buy TIPS under these scenarios.

TIPS can be volatile. If purchased and held to maturity, TIPS investors will receive income plus inflation protection, but in the interim period, investors are subject to price appreciation or depreciation, just like any fixed-income security. If an investor has to sell their TIPs prior to maturity, any inflation protection she or he may have gained could be lost. Moreover, TIPS tend to have longer cash flow duration than nominal U.S. Treasuries. As real yields decline, which they have in the past year, TIPS can and have exhibited more volatility than nominal Treasuries.

Inflation Factor

In broad terms, the years following World War II through the late 1970s were a reflationary period while the years since have been disinflationary. The average inflation rate during the 1950s-1970s was roughly 3%. If we thought inflation was going to return to that level, then TIPS might be an appropriate strategy; particularly with ten-year TIPS, as their current breakeven rate is 2.4% (longer, 30-year TIPS currently have a higher breakeven rate of 2.9%, making the transaction less compelling). While we believe disinflationary forces have just about run their course and that the next decade will bring higher inflation levels, we are not concerned that inflation is about to move rapidly higher. As a result, we are taking a measured, case-by-case approach toward adding TIPS to portfolios. Our decision on when and where to use TIPS, like any fixed-income security, is based on our market views and the specific needs and risk tolerances of each of our clients.

Dan Fuss, CFA, is vice chairman and portfolio manager and John Hyll is a vice president and portfolio manager with Loomis, Sayles & Co.