The TIPS spread

on Sep 13, 2012 in Fixed Income, Home | 1,563 comments

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The US Treasury sells notes of different yields and maturities. One type of those notes is known as TIPS or Treasury Inflation Protection Securities. A TIPS note’s yield moves based on changes in the level of CPI or consumer price inflation. If CPI or inflation is rising, the face value of a TIPS note increases and similarly the face value may fall if CPI falls. This means that TIPS are a hedge against inflation!

Comparing the yields between Treasury securities and TIPS can provide a useful measure of the market’s expectation of future CPI inflation. Why? The yield-to-maturity on a Treasury bond that pays its holder a fixed nominal coupon and principal must compensate the investor for future inflation. Thus, this nominal yield includes two components: the real rate of interest and the inflation compensation over the maturity horizon of the bond. For TIPS, the coupons and principal rise and fall with the CPI, so the yield includes only the real rate of interest. Therefore, the difference, roughly speaking, between the two yields reflects the inflation compensation over that maturity horizon.

The wider the spread between the two yields, the higher investors’ expectations are and vice versa.

From a fundamental perspective it seems that we can count on higher levels of inflation in the long term. From a portfolio management perspective TIPS are a good way to add protection against inflation and to insert an element of fixed income to your diversification strategy.

Bottom line: Higher rates of inflation can be turned into an opportunity at the investor’s discretion.