You are missing the bond deal of the decade - and it is guaranteed to beat inflation

By Mark Hulbert

TIPS are offering a rare gift - and it is time to lock in a generous payout

A TIPS ladder gives your portfolio a strong firewall against inflation.

It is an especially opportune time to buy U.S. Treasury inflation-protected securities (TIPS), since real interest rates are above their 10-year average.

This advice will come as a surprise to those who have accepted the popular narrative that real interest rates - the difference between U.S. inflation and reported, or nominal, rates - fell to negative levels earlier this year as inflation worsened. That narrative supports the belief that nominal rates must rise for real rates to return to positive territory.

That may be accurate for extremely short-term rates such as the fed-funds rate, which is the rate the Federal Reserve sets. But when it comes to interest rates of 1-year maturity or longer, this belief betrays a fundamental confusion about how to calculate real interest rates: Instead of comparing current interest rates with trailing (past) inflation, real rates reflect the difference between nominal rates and expected future inflation. Doing the calculation that way, current real rates are not only positive but actually higher than their 10-year average.

This is shown in the chart above. It reflects the difference between the nominal 1-year Treasury bill BX:TMUBMUSD01Y and the 10-year Treasury note BX:TMUBMUSD10Y and expected 1- and 10-year inflation as calculated by the inflation expectations model from the Federal Reserve Bank of Cleveland.

The 10-year real (after inflation) yield was recently 2.1%, 1.2 percentage points higher than the 10-year average of 0.9%. The 1-year real yield stands at 2.2%, 1.9 percentage points higher than the 10-year average of 0.3%.

The investment implication is that it is a good time to invest in a TIPS ladder, thereby locking in relatively high real rates. According to the TipsLadder.com website, a 30-year TIPS ladder produces a guaranteed inflation-adjusted withdrawal rate of 4.9% annualized over the next 30 years, and a real yield (after inflation) of 2.7% annualized. Earlier this decade, the comparable withdrawal rate was just over 4.0%.

What you're locking in with a TIPS ladder is how much you will earn above inflation. Once established, you won't need to care about whether inflation turns out to be higher or lower than the Cleveland Fed model is forecasting.

That's not a bad trade-off. Still, a fair objection to this analysis is that it is based on projections rather than reality. The Cleveland Fed's model could be wrong, after all. Doesn't that make a bet on lower real rates quite speculative?

All investment forecasts are speculative, of course. But the Cleveland Fed's forecasts use a sophisticated model based on "Treasury yields, inflation data, inflation swaps, and survey-based measures of inflation expectations." A lot would have to be wrong for the model's forecasts to be way off base.

Take the inflation swaps that are just one of the inputs to the Cleveland Fed's model. These are derivative contracts whose payoffs are tied to inflation, and the total notional value of the global swap market is in the trillions of dollars. Or consider the TIPS market, whose yields are another input to the Cleveland Fed's model; its market is estimated at $2 trillion.

In both markets, traders haggle over differences in expected inflation of just a single basis point (0.01%). What makes you think you have a better crystal ball than full-time traders with collectively trillions of dollars at stake?

Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at mark@hulbertratings.com

-Mark Hulbert

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