Inflation-Indexed Securities

[HardDrive]

I don't really see how we can avoid a period of dramatic inflation in the next decade. Not buying the doomsday scenarios, but all those giant piles of cash in the reserve banks need to hit the streets someday.

I was doing some research into Inflation-Indexed Securities. I like the idea in principle, but these are products offered by the US government. Given the gravity of the fiscal situation facing our country, I don't feel confident the terms of my investment would honored.

Are there products out there pegged to CPI that do not rely on government bonds?

[lukeh]

This might give you what you need.

Inflation-indexed bond - Wikipedia, the free encyclopedia

People have been buying the TIPS for the past 4ish years and earning next to nothing as they thought inflation was about to take off. Well here we are 4 years later and they are still waiting. My question is why not wait until inflation starts to jump way up and then buy them? That seems to make more sense that buying them when inflation is low and then waiting for it to go up.

[TheMentat]

This might give you what you need.



Inflation-indexed bond - Wikipedia, the free encyclopedia



People have been buying the TIPS for the past 4ish years and earning next to nothing as they thought inflation was about to take off. Well here we are 4 years later and they are still waiting. My question is why not wait until inflation starts to jump way up and then buy them? That seems to make more sense that buying them when inflation is low and then waiting for it to go up.

The problem with waiting is that these securities tend to be priced according to EXPECTED future inflation and interest rates. I suspect that prices on TIPS will have spiked long before it becomes generally accepted that inflation has taken hold. If you buy after prices have spiked, you will simply earn a lousy yield, unless inflation is higher than expected.

[lukeh]

Originally Posted by TheMentat

The problem with waiting is that these securities tend to be priced according to EXPECTED future inflation and interest rates. I suspect that prices on TIPS will have spiked long before it becomes generally accepted that inflation has taken hold. If you buy after prices have spiked, you will simply earn a lousy yield, unless inflation is higher than expected.

I must be missing something...

Why is the price of the bond moving so much if the coupon is moving at the same time? Is it not true that the interest rate on TIPS bought 4 years ago will be the same as what TIPS are currently being issued at? I mean if all the TIPS are following the same inflation index shouldn't they all be paying the same interst rate no matter when they were issued?

What am I missing?

[TheMentat]

Originally Posted by lukeh

I must be missing something...

Why is the price of the bond moving so much if the coupon is moving at the same time? Is it not true that the interest rate on TIPS bought 4 years ago will be the same as what TIPS are currently being issued at? I mean if all the TIPS are following the same inflation index shouldn't they all be paying the same interst rate no matter when they were issued?

What am I missing?

Not sure what you are missing, but here is my rationale:

The price you should pay for a bond is the expected future payments, discounted by corresponding interest rates for those terms.

With a regular bond the payments are known with certainty, so we simply discount the future coupon and principal payments by rates found on the yield curve.

With a TIPS, you have to make an assumption about what inflation is going to be over the life of the bond. Using that assumption, you can figure out what your payments will be, and discount those payments the same way as you did with an ordinary treasury bond. With this in mind, if we look at pricing on TIPS, we can see what "the market" believes future inflation will be by comparing them to nominal Treasuries.

If you go and buy a TIPS, and inflation behaves exactly as as "the market" expects, you won't make much more money than if you had simply bought a normal treasury bond (think about it... otherwise you could simply short a nominal bond, and use the proceeds to buy a TIPS, and be guaranteed free money as the coupons on the TIPS were gradually re-indexed higher)

The way you make money on a TIPS (over and above the money earned on a nominal bond) is if inflation turns out to be higher than the market expected when you bought the bond.

Does that make sense?

[jyl]

I think four years ago folks on this board were confidently predicting hyperinflation by now.

[HardDrive]

I'm not predicting hyperinflation. I'm predicting a steady rise in inflation over the next decade.

[lukeh]

Originally Posted by TheMentat

Not sure what you are missing, but here is my rationale:

The price you should pay for a bond is the expected future payments, discounted by corresponding interest rates for those terms.

With a regular bond the payments are known with certainty, so we simply discount the future coupon and principal payments by rates found on the yield curve.

With a TIPS, you have to make an assumption about what inflation is going to be over the life of the bond. Using that assumption, you can figure out what your payments will be, and discount those payments the same way as you did with an ordinary treasury bond. With this in mind, if we look at pricing on TIPS, we can see what "the market" believes future inflation will be by comparing them to nominal Treasuries.

If you go and buy a TIPS, and inflation behaves exactly as as "the market" expects, you won't make much more money than if you had simply bought a normal treasury bond (think about it... otherwise you could simply short a nominal bond, and use the proceeds to buy a TIPS, and be guaranteed free money as the coupons on the TIPS were gradually re-indexed higher)

The way you make money on a TIPS (over and above the money earned on a nominal bond) is if inflation turns out to be higher than the market expected when you bought the bond.

Does that make sense?

I'm still missing something and will need to read up more. I thought you bought TIPS to beat inflation. If inflation goes up so will the interest on your bond. So let's say I bought TIPS 4 years ago and inflation was at 2% my bond would pay 2.5%. Then let's say inflation 2 years later jumps to 4%. My understanding is the rate on my TIPS would reset to 4.5%. So no matter how high inflation goes I'll be .5% (or whatever they pay over inflation) higher. I might be thinking I-bonds but I thought TIPS worked similar to this. Am I correct in that the rate TIPS pay fluctuate with inflation?

If the rate does fluctuate with inflation wouldn't TIPS bought 4 years ago pay the same rate as TIPS being issued today?

[jyl]

The point is that if inflation in the future is expected to be 5%, the TIP bond today will be priced (high) based on future payments consistent with 5% inflation. So you don't get any especial return for buying it. The only way you make an especial return is if future inflation is expected to be 5% but it actually turns out to be higher, say 7% (numbers as examples only). So, do you feel able to forecast future inflation better than the professional investors whose bidding determines TIP prices?

[HardDrive]

I had I bonds in mind when I posted this. TIPs are a different animal, one I will need to examine in the morning.....ZZZzzzzzzzz....

[KFC911]

Originally Posted by jyl

I think four years ago folks on this board were confidently predicting hyperinflation by now.

Which made no sense whatsoever to me at the time (after the housing bubble collapse and with consumer credit almost non-existant)...it was in fact a period of deflation like we haven't seen in my lifetime imo.

Originally Posted by HardDrive

I'm not predicting hyperinflation. I'm predicting a steady rise in inflation over the next decade.

Though I was a teen....I remember hyperinflation from the late 70s. Since then, imo we've always had a steady, modest rise in inflation. Just take a look at almost anything, from housing, cars, gasoline, gold, etc. back then and the trends over the past 4 decades.

Though I diversify over several asset classes, I tend to go for individual stocks of solid companies with a long track record of paying (and increasing) dividends, and that has worked well for me over the years. I average slightly over 5% returns (dividends only), and imo the inflation-protection is "built in" to the stock price over time. I also figure that a solid "corporate bond" fund has a similiar "built in" protection. Just my .02 worth...YMMV.

[TheMentat]

Originally Posted by jyl

The point is that if inflation in the future is expected to be 5%, the TIP bond today will be priced (high) based on future payments consistent with 5% inflation. So you don't get any especial return for buying it. The only way you make an especial return is if future inflation is expected to be 5% but it actually turns out to be higher, say 7% (numbers as examples only). So, do you feel able to forecast future inflation better than the professional investors whose bidding determines TIP prices?

Thanks John... I have a tendency to over-complicate things!

[74-911]

Originally Posted by HardDrive

I had I bonds in mind when I posted this. TIPs are a different animal, one I will need to examine in the morning.....ZZZzzzzzzzz....

Unfortunately, the fixed rate on I bonds has been zero for quite a few years now. I bonds bought 10-12 or more years ago were good investments and will be even better if (or should we say when) inflation kicks in.

[jyl]

[Edit: following comment refers to traditional fixed rate bonds, not TIPS.]

Why will fixed rate bonds be good investments in a high inflation environment, if that is what you expect?

The coupon payment is fixed, so it is worth less in real dollars (the classic misery of living on a fixed income in a high inflation period).

And high inflation usually means interest rates rise. Rising interest rates mean bond values decline. So not only is your fixed coupon payments not keeping up with inflation, but you are taking capital losses on the bond.

I don't pretend to be a bond expert - not my field - but I'd have to hear a pretty good argument to make me think fixed rate bonds are a good place to be if you think future inflation will be high.

[HardDrive]

Originally Posted by jyl

I don't pretend to be a bond expert - not my field - but I'd have to hear a pretty good argument to make me think fixed rate bonds are a good place to be if you think future inflation will be high.

Thats just it, they are not fixed rate. The rate is tied to the Consumer Price Index. So as CPI goes up during a period of inflation, your rate goes up with it. At least that is my caveman understanding of them.......

[jyl]

Originally Posted by HardDrive

Thats just it, they are not fixed rate. The rate is tied to the Consumer Price Index. So as CPI goes up during a period of inflation, your rate goes up with it. At least that is my caveman understanding of them.......

Sorry, I wasn't clear - my last post was referring to traditional fixed rate bonds, it was a response to 74-911's post which I thought was also referring to those sorts of bonds. I guess we are kind of talking about both TIPS and fixed rate in the thread, either that or I am mis-reading things.

And just to make sure the vocabulary isn't causing any mis-understanding - by fixed rate I mean a bond that pays a coupon that is a pre-determined and unchangeable percentage of face value.