Inflation Adjusted Treasuries: Why TIPS Aren’t The Safest Place For Your Money Right Now

by Alexander Green, Chairman, Investment U
Investment Director, The Oxford Club
Monday, January 14, 2008: Issue #751

When I was 16, my buddies and I drove three hours to Newport News, Virginia, to see The Who in concert. Two hours before the show, the ring outside the coliseum must have been 20-people deep. When the doors finally opened, thousands of kids went cascading in at once.



Ticket takers were bowled over. People were falling down and getting trampled. Shoes were flying everywhere. Girls were screaming. There was pandemonium. It was a surreal experience. And, looking back, it taught me something about investing, too. When the crowd turns into an unruly mob, get the heck out of the way.

People can’t seem to resist moving in herds when they’re investing, whether they’re galloping toward Internet stocks, commodity plays or residential real estate. And right now, they’re piling into inflation adjusted Treasuries - or TIPS - at precisely the wrong time.

Over the past few years, I’ve been recommending inflation-adjusted Treasuries to readers. But if you don’t own them yet, don’t buy them just now. Here’s why…

Inflation-Adjusted Treasuries - A New Class of Gov’t Bonds

Inflation-adjusted Treasuries are a relatively new class of government bonds. They made their debut in 1997.

• Inflation-adjusted Treasuries pay interest every six months, just like a regular Treasury bond. But, unlike traditional bonds, your principal increases each year by the amount of inflation, as measured by the consumer price index (CPI). Semi-annual interest payments also increase by the amount of inflation. The interest you receive is exempt from state and local (but not federal) income taxes. And like other Treasuries, your investment is backed by the full faith and credit of the U.S. government.

• Inflation-adjusted Treasuries are less volatile than traditional bonds. They are also excellent diversifiers. Ordinarily, they will reduce your overall portfolio risk. But if you don’t own them, wait for them to get cheaper.
• Inflation-adjusted Treasuries are no bargain right now. With the stock market hitting the skids, many investors are seeking a haven for their money.

As a traditional harbinger of inflation, gold has been pushing higher, too. That’s led many investors to believe that inflation-protected U.S. government bonds are the safest investment around. And, as is often the case, everyone seems to have gotten the idea at precisely the same time. That has sent inflation-adjusted Treasuries soaring to lofty levels.

An Easy Way To Track Inflation-adjusted Treasuries

An easy way to track inflation-adjusted Treasuries is through an exchange-traded fund, the iShares Lehman TIPS Bond Fund (AMEX: TIP). It strives to replicate the return of the Lehman Brothers U.S. Treasury Inflation Notes Index. This fund has surged 10% since last summer, a big move for Treasuries. With bonds, of course, when the price rises, the yield falls. The “real” or after-inflation yield on the benchmark 10-Year TIP has plunged by nearly half, from over 2.8% in August to just 1.5% today.

If history is any guide, that makes these securities a very poor bet right now. Only twice in recent history have real yields fallen to similar levels: In early 2004, and again in 2005. On both occasions, those who invested quickly lost money as the bonds fell back again and the yields rose.

The Best Time To Buy Inflation-adjusted Treasuries

The best time to buy inflation-adjusted Treasuries is when they are out of favor and the real yield is 2% or higher. I’ll notify you when yields reach this level and the bonds become attractive again.

Don’t get me wrong. If you own inflation-adjusted Treasuries as part of your asset allocation, by all means stick with them. (It doesn’t pay to jump in and out of them, paying commissions, covering the bid/ask spread and paying capital gains taxes.) But please don’t think of them right now as a safe place to park your money until the market starts acting better.

As any Who fan can tell you, it’s safer to avoid the herd.

Good investing,

Alex

Today’s Investment U Crib Sheet

• So where’s a safe place for your money right now?
  The Vanguard Prime Money Market Fund (VMMXX) is paying 4.5%, compared to the 10-Year Treasury’s 3.8%. It’s liquid. It’s safe. And expenses are practically non-existent.

• You’ll also want to check out the iShares S&P National Municipal Bond Fund (AMEX: MUB), as Alex pointed out in The First No-Brainer of 2008. This ETF, and tax-free bonds in general, should outperform in the coming months.
• What about gold? At last check, the yellow metal traded for $895 an ounce. It’s up nearly $50 an ounce in the last two weeks. And it’s more than tripled since 2000. How much higher could it go? Check out last week’s article from Dr. Mark Skousen, 3 Reasons this Precious Metal Should Be In Every Portfolio.

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• Hedge Funds… The Biggest Threat Facing the Stock Market Today
• Mergers and Acquisitons (Part 1): Here’s How to Take Advantage of The Takeover Frenzy
• Contrarian Investing… Be Brave. Be A Contrarian With These 2 Stocks

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