I Don’t Like TIPS

Treasury Inflation Protected Securities – TIPS – I do not like them, Sam I Am.  Let me count the ways.

Let’s start with the name.  It’s a gross misrepresentation.  These securities are adjusted by the Consumer Price Index – CPI – not for inflation.  There are at least two undemonstrated assumptions embedded in this discrepancy.  First, that consumer prices properly represent inflation.  Second, that the CPI properly represents consumer prices.  If any reader has a cogent argument for either of these assumptions, please reveal it.  I have never seen one.

They are far from obvious on their faces.  It’s beyond doubt that US domestic consumer prices are only a small subset of all prices.  Despite the fact that the US dollar is the most widely traded security in the world, they don’t include transaction prices outside the US.  They also don’t include vast swaths of prices within the US, such as crude oil, copper, gold or most other raw materials.  Such prices are reflected in final goods only with long and variable lags, and so consumer prices are perpetually behind.  They also don’t include trillions worth of assets like stocks, bonds, and commercial real estate.  They don’t include wages or labor prices.  That these prices are unaffected by and don’t represent inflation – depreciation of the currency – is patently false, yet the media perpetuate the myth that inflation is equivalent to rising consumer prices without critical examination.  The CPI wasn’t even originally designed to gauge inflation … just like the name says, it was created as an index of consumer prices.

That the CPI doesn’t even accurately represent the subset of US domestic consumer prices at least gets some media attention outside so called mainstream sources.  So there’s no need to belabor it here.  Suffice it to say it does not include extremely significant prices such as those for homes, and uses highly questionable tactics such as “hedonic” adjustments for supposed increases in quality of various consumer goods.  This is not only technically doubtful, but premised on the more fundamental assumption that even unchanging things are unchanging in value in the first place.  That the same buggy whip is worth the same in 2022 as in 1922 isn’t exactly a given.  And that a 2022 iPhone would be worth the same as a 1922 iPhone is absurd.  Yet this is the assumption underlying the use of things as a reference value.  Finally, as technology lowers the cost of of producing the same goods over the years, that that somehow represents deflation is preposterous. It does not represent currency appreciation and therefore cannot act as an offset to currency depreciation.  The notion of “correcting” for it is tantamount to the government claiming for itself all the benefits of technological advance.

The misrepresentation alone is enough to dislike TIPS.  But we’re far from done.  Even if you received an accurate adjustment for inflation you would still realize a negative real return.  Why?  You aren’t taxed on only your real gains, but your nominal gains.  If inflation is 10% over a given time frame and you netted an offsetting 10% nominal gain on your TIPS, you’ve broken even.  But you will pay tax on your nominal gain, so that your nominal after tax will be closer to 8%.  Presto inflation has just cost you 2% on your supposedly inflation protected investment.  To be fair, nominal gains taxation would apply to any investment, but for something that purports to protect from inflation it’s inexcusable.

Next up is the fact that the “real yield” on TIPS is lower than the nominal yield by – guess what – the amount of expected inflation.  A simple ten year Treasury yesterday yielded 2.91%.  Its “inflation protected” counterpart just 0.21%.  In other words, based on expected “inflation” the markets have arbitraged away all of the supposed protection versus nominal bonds.  The actual “inflation protection” turns out to be only the amount by which inflation – actually the CPI – exceeds expectations at the time of your purchase.  Aside from that the ordinary bond includes just as much “inflation protection” as the “inflation protected” one … it’s just baked into the nominal yield.

Even with the multiple layers of misrepresentation, there might be a case for investing in TIPS if there weren’t superior alternatives.  But there are.  Stocks in particular offer vastly better inflation protection.  But you want diversification from stocks you say?  It turns out that TIPS are also much more highly correlated with stocks than ordinary Treasuries.  You may as well just own a higher allocation to stocks and use ordinary Treasuries.  Skip the added complexity and self deception that you’ve somehow done something to improve your risk adjusted return. 

Adding commodities helps too.  You get market based inflation protection, free from self serving government statistical manipulation.  That includes gold as well as other hard commodities like copper, silver and platinum.  Most commodity index funds include energy and agriculture as well.  When it’s all said and done, if you’re worried about inflation, you’re better off allocating to stocks, bonds, commodities and other real assets, the same as you always would, and just adjusting your asset mix to reflect the amount of inflation protection you want.

So since they’re completely useless to investors, do TIPS even have any reason to exist?  Yes.  Because of the aforementioned arbitrage, they provide economists and policymakers with a read on market expectations for the future trajectory of the CPI.  Of course to the extent they are misleading themselves about the trajectory of inflation, even there they’re a net negative.  Considering the foregoing, for the rest of us, they’re actually worse than useless too.  We’re better off with green eggs and ham.

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