Investing in Tips

[SmallCap]

I have become more interested in investing in Tips and am trying to figure out what the best way to get exposure to them.

 

My basic theses:

From my rather amateurish assessment of the macro economy it appears to me that we are heading towards either Deflation or significant inflation. What I do not see at this point is our resuming the nice smooth 0%-3% inflation on a steady basis that we have experienced over roughly the last 20 years(yes there are a few exceptions in there). I foresee (wow, does that ever sound pretentious) either Deflation or significant inflation in the next few years. I have read a lot of views on which of these we will experience in the next few years and while I lean towards the inflationary view I really don't feel that I can say so with any confidence. So here is the reason I like Tips:

 

In an inflationary period:

Well I think this is fairly obvious how this will do in an inflationary period, some asset classes will do better but many will do worse.

 

In a deflationary period:

Surprisingly this is where I like tips because most asset classes that do well in an inflationary time will get killed in a deflationary time while Tips will hold their dollar value which in a deflationary time that is exactly what I want and when I sell these tips for their face value after deflation I can reinvest that money in assets with deflated prices.

 

In a period of little change:

This is in my opinion where Tips don't shine at all. Lets say that inflation is in the range of -2% up to +3% such as we have had for the past 20 years. in this environment Tips will hold their value  but there are so many other asset classes that would be better.

 

Summary

if I could predict that there would be inflation then I would direct my investments towards companies that have an advantage in that environment such as ones with lots of long term debt and pricing that will increase with inflation such as energy. If I could predict deflation then I would invest in Gov bonds. But I don't see a clear answer about which way it will go and so I wanted something that will do well in either environment.

 

So that is the reason I am interested in Tips and if anyone can show me the error of my thinking I would appreciate it.

 

but now on to my question. what is the best method of investing in Tips, should I open a treasury direct account and buy them at an auction or purchase them on the open market with my broker or should I go the simple easy route of buying into a Tips mutual fund and what are the downsides of owning them in a fund?

 

Also can someone explain in what way or in what situations a I bond is a better option then a Tips bond?

[vinod1]

I do not think there is any error in your scenario analysis of TIPS. I have pretty much written the same about TIPS in the past on this board.

 

Here are a few additional points

 

1. If you are looking for absolute valuation of TIPS, you might think of a real 3% yield as being very attractive. TIPS are very unlikely to be able to maintain a real yield greater than 3% for any sustained period of time. There are both theoretical and empirical reasons (based on the last 60+ odd years of data on inflation protected bonds from several countries) why this should be so.

 

2.  To get deflation protection you need to buy TIPS close to par or else you would lose the deflation protection.

 

3. To really tailor your portfolio of TIPS to match the above you need to buy individual TIPS not TIPS funds.

 

4. You can buy from treasury direct only in a taxable account since most custodians of retirement accounts would not allow you to purchase from TD.

 

5. I-Bond is good when you get a decent real yield comparable to TIPS. The main advantage is that you can redeem it at any time after one year and your principal would not fluctuate. It is almost like a inflation protected savings account! The downside is that they have changed the max amount you can buy to a ridiculously small amount ($5000 per year per person I think) and also the real yield is pretty low compared to TIPS.

 

Vinod

[Packer16]

What about a scenario where the $ declines by 50% and there is little inflation in the US due to a the small impact import prices will have on overall prices and the deflationary effects of deleveraging.  The yen/euro, yuan and commodities will all rise but not effect inflation because they are a small portion of the prices of end goods and services.

 

Packer