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A Primer on TIPS

You may have noticed over the past several months our increasing use of Treasury inflation-protected securities (TIPS) in portfolios. We realize TIPS are quite foreign to many, so I’d like to take a few moments to describe how TIPS work and why you have some of your money in them.

First, we must admit our foray into TIPS has come with some educational amusement. When we started buying TIPS a few months ago, a veteran trader at a large brokerage confessed we were the first money manager to ever give her a TIPS order. This trader has probably executed over the past few years billions of dollars worth of the complex and even toxic forms of debt securities that are at the heart of the current financial crisis—but inflation-indexed Treasuries? Never.

We have received similar feedback from other brokers since then and have learned that few investment professionals understand how TIPS work, and even fewer have ever used them. This, we believe, is a good sign; and we hope we are getting in before Wall Street realizes the inflation threat shouldn’t be ignored.

The return of inflation

Perhaps the biggest reason for Wall Street’s inexperience with TIPS lies in the success of the Federal Reserve in taming inflation over the past two decades. A generation of bond investors has been able to virtually disregard inflation risk when deciding whether to buy fixed income securities, focusing instead on credit quality and the direction of the Fed and interest rates. The idea that inflation may rise and erode the value of the bond’s fixed coupon payments has been largely vacant in the market’s collective mind.

At least for now, we believe that investors can no longer be so sanguine on inflation. America’s epic unwinding after years of excessive risk-taking fueled by abundantly cheap credit has been met with a collective solution by the Fed, Treasury, Congress, and the White House: print money. The Fed has abandoned inflation-targeting and has aggressively lowered interest rates while working with the Treasury to bailout embattled homeowners, banks, and the massive Fannie Mae and Freddie Mac. Congress and the White House have issued $150 billion in “stimulus” checks with possibly more on the way.

In addition to Washington’s check writing, a weak dollar and soaring commodity prices are already working their way into higher inflation. Inflation, as measured by the Consumer Price Index, has risen to 5 percent. This should worry bond investors holding onto low, fixed coupon bonds.

How TIPS work

TIPS may serve as investors’ most direct hedge against higher inflation. TIPS work as follows. Like Treasuries, the coupon on a TIPS issue is set at a fixed rate (albeit a lower one than comparable traditional Treasuries). Over time, however, the face value—or par value—of the TIPS is adjusted for inflation. The inflation index the government uses is the Consumer Price Index for All Urban Consumers (CPI-U). Because the par value of a TIPS increases over time (assuming the inflation rate is greater than zero), interest payments also increase over time because the coupon payment is applied to an increasing par value. At the maturity date, the investor gets a par value that includes all inflation adjustments over the life of the TIPS.

Inflation a contrarian fear

Since principal adjustments and interest payments rise with inflation, holding TIPS hedge investors from inflation. Where TIPS can be really beneficial is when inflation is unexpectedly higher than the market assumes. We believe we are in this situation now; the market, guided mostly by Keynesian economic arithmetic—that is, growth as inflationary and slowdown/recession as disinflationary—believes inflation will snap back to near 2 percent levels starting as soon as next year. Our more Monetarist interpretation of inflation—too much money chasing too few goods—suggests the market may be too optimistic on a perfect inflationary dismount.

We could be wrong on this—the current inflation may turn out to be a temporary flareup. However, with near historically low yields, the market seems “priced for perfection” on the inflation front, leaving traditional bond investors in a precarious position should inflation moderate slower than expected or should inflation continue rising.

TIPS pricing

You may have noticed a discrepancy between our statements and your brokerage’s regarding the market price of your TIPS. In general, the TIPS price on your brokerage statements will appear lower than on our statements. This is because many banks and brokerages show TIPS securities priced for $100 par value, not current par value with all accumulated inflation adjustments. Our statements reflect all inflation adjustments and therefore offer a more accurate (albeit higher) estimation of the market value of your TIPS.

I hope this primer helps. As always, please call us if you have any questions or comments.

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The Cadinha Team




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