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TIPS vs. Nominal Treasury Bonds

TIPS (Treasury Inflation-Protected Securities) are US government bonds that provide a specific after-inflation return (i.e., “real return”) as compared to traditional “nominal” bonds which provide a specific before-inflation return.

We’ve discussed before when it makes sense to use individual TIPS as opposed to TIPS funds. But we’ve never discussed when to use TIPS at all — as opposed to nominal Treasury bonds.

What Inflation Do You Expect?

The most obvious way to choose between TIPS and nominal treasury bonds is to compare the market’s inflation expectation to your own inflation expectation.

For example, as I’m writing this, the yield on 10-year TIPS is 1.01%, and the yield on a 10-year nominal Treasury bond is 2.64%. What we can conclude here is that the market is estimating inflation will average roughly 1.63% (2.64% minus 1.01%) per year over the next decade.

If you expect inflation to be above the market’s expectation (1.63% in this case), TIPS are a better bet. If you expect inflation to be below the market’s expectation, go with nominal bonds.

What if you don’t have any guesses about inflation?

Of course the above analysis isn’t particularly helpful if, like me, you don’t spend much time pondering what the rate of inflation will be over any given period. If that’s the case, you’ll have to come up with another way to choose your allocation between TIPS and nominal bonds.

In such a scenario, the most important differences between TIPS and nominal bonds are that:

  • TIPS make planning easier, but
  • Nominal bonds may be more useful as a diversifier of a mostly-stock portfolio.

Using TIPS for Planning

In almost every situation, inflation-adjusted returns are more meaningful than nominal returns. As such, TIPS’ inflation-adjusted yield makes them much more useful for planning purposes.

For example, TIPS can be an excellent tool for retirement portfolios. While they’re not risk-free, TIPS can be used to provide a high degree of safety for sustaining a given (low) inflation-adjusted withdrawal rate (e.g., liquidating 3% of your portfolio in your first year of retirement, then increasing the dollar amount that you liquidate each year in order to keep up with inflation).

Bonds as a Diversifier

If you’re only holding a small amount of bonds, and you’re doing it solely to reduce the volatility of a mostly-stock portfolio, nominal bonds may be the better bet. The reason is that, in crisis scenarios, investors tend to flock toward extremely safe investments — especially nominal Treasuries. As a result:

  • Nominal Treasury bonds seem to perform better during market crashes, and
  • Nominal Treasury bonds’ correlation to stock market returns has been lower than that of TIPS.

That said, TIPS are still relatively new, so these conclusions are based on a very small amount of data.

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  1. What no mention of I Bonds? TIPS in a taxable account tend to eat away at your inflation gains. TIPS for the most part should go in retirement accounts. I Bonds in your taxable allocation.

  2. Am I paranoid for being wary about a conflict of interest here? The (insolvent) entity who has to make good on TIPS is also the entity who decides what the official rate of inflation is, right?. Inflation is a soft enough figure that I have no doubt it could be fudged half a percentage point south if it was convenient to do so. If TIPS became a popular investment vehicle, there could be considerable institutional pressure to decide the lower number was the ‘right’ one.

  3. Yes, the US government is the party that gets to decide how to calculate CPI, which does expose a TIPS investor to some degree of related risk.

    On the other hand, the US government is also (to a degree) in charge of inflation itself. So a case can be made that an investor in nominal Treasuries is exposed to the risk that the US government will intentionally cause inflation, thereby reducing the real return the investor receives.

  4. It’s not as simple as what your expectation for inflation is. TIPS are also about insuring against worse-than-expected inflation. If TIPS are priced for 1.5% inflation, and I expect that inflation is likely to be 1% with a small probability of it being 50%, it could make sense for me to pay a “premium” for TIPS as insurance.

  5. You’re right. And on the other side, buyers of nominal Treasuries are supposedly paying a slight liquidity premium.

    That’s why I used the word “roughly” above, as I don’t know of any way to calculate the value of these two premiums.

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