Investors who believe inflation will average more than 1% per year over the next 10 years should consider establishing or adding to their TIPS allocation. Since 1950, there has never been a rolling 10 year time period when the Consumer Price Index (CPI)¹ averaged 1.0% or less. Supply/demand dynamics are also shifting in TIPS’ favor due to enormous conventional Treasury issuance ahead without an expected increase in TIPS issuance.

Question #1: Given the extraordinary credit market conditions over the past year, how have Treasury Inflation Protected Securities (TIPS) performed?

Answer: A massive flight to quality and falling commodities prices led nominal Treasury securities to substantially outperform TIPS since mid-year. This reverses the trend from 2007 and the first half of 2008 when nominal Treasuries trailed TIPS. Though TIPS have underperformed nominal Treasuries, they have significantly outperformed corporate bonds and asset-backed securities. The generous income stream from a high inflation environment has helped lift returns.



Question #2: What led TIPS to underperform nominal Treasuries?

Answer: TIPS underperformed as inflation expectations collapsed in the context of plummeting commodities prices and a growing realization that the economy was in a recession. The break-even inflation rate² for 10-year maturities fell from 245 basis points on June 30th to 150 basis points on September 30th and to 88 basis points by October 31st. Inflation protection has rarely been this cheap before.



Question #3: Does the current break-even inflation rate of 0.88% on 10-year TIPS imply that average annual inflation, as measured by the CPI, will be 0.88% over the next 10 years?

Answer: Not necessarily. There are a variety of other factors such as liquidity and supply/demand dynamics that affect the break-even inflation rate. Nevertheless, if inflation averages more than 0.88% annually over the next 10 years, TIPS will outperform nominal Treasury bonds of the same maturity. Since 1950, rolling 10-year CPI has rarely averaged less than 2%, and has never been less than 1%.





Question #4: With the economy in a recession, what happens if the rate of inflation is negative?

Answer: Investors have now priced in deflation over the next seven years — a very pessimistic outcome. That is far worse than Japan experienced in its ‘lost’ decade. While there may very well be deflation over the next year due largely to falling energy prices, CPI would have to fall more than 4% for TIPS to underperform one year nominal Treasury bills. Over an intermediate horizon, we believe the more likely scenario is a normalization or acceleration of inflation as a result of unprecedented government stimulus now in place, with more to come. Over the past 15 months, the Fed has increased lending by over $1.5 trillion with a wide variety of programs intended to provide liquidity to the financial system. It also lowered the Fed Funds rate from 5.25% to 1.00%, and lowered the Discount Rate from 6.25% to 1.25%. Meanwhile, the Treasury agreed to support the senior and subordinated debt of FNMA and FHLMC, loaned AIG $150 billion for two years for an 80% ownership stake, and plans to spend up to $700 billion to purchase distressed structured securities and inject capital directly into the country’s leading banks. Another fiscal stimulus plan is also now likely once Congress reconvenes. There will be a great deal of stimulus in place when the economy eventually recovers from its cyclical downturn.




Question #5: What impact will the dramatic decline in home prices have on inflation?

Answer: To the surprise of many, the decline in home prices has not had a direct impact on the calculation of the CPI. Housing costs impact CPI through a calculation known as “owners’ equivalent rent” (OER). OER currently accounts for 24% of the CPI basket used to adjust the principal component of TIPS. The calculation of OER is based on the assumption that homeowners are essentially leasing their primary residence from themselves. Changes in the value of OER reflect changes in the rents charged for similar housing units. Ironically, rising foreclosures and increasing demand for rental units may cause OER to accelerate. While the direct effects of collapsing home prices may not be significant to the CPI, the indirect effects are surely disinflationary. Housing market woes are the primary catalyst of a consumer retrenchment and the current recession. Lower consumer inflation, stemming from lower consumer demand, has its origins in home price dynamics.



Question #6: I don't have a strong view on inflation so is there any reason to add TIPS to a diversified portfolio?

Answer: Since inception, TIPS have been additive to portfolio returns while limiting volatility. Over the past 10 years ending September 30, 2008, the correlation between the Lehman U.S. TIPS Index and the Lehman U.S. Treasury Index was approximately 80%³, so TIPS have brought beneficial diversification while enhancing return.
From a strategic perspective, TIPS protect a portfolio of assets from periods of unanticipated inflation while assuring investors a U.S. Treasury guaranteed real return stream. From a tactical perspective, we believe supply/demand dynamics are shifting in favor of TIPS. TIPS now represent approximately 15% of all outstanding marketable U.S. Treasury debt — equal to the Treasury’s long-term issuance target. To reach this target, TIPS have represented significantly more than 15% of total Treasury issuance since they were first auctioned in 1997. Over the next year, there is a growing expectation that the U.S. Treasury's enormous prospective financing needs will be funded primarily by larger conventional Treasury issuance, with less reliance on TIPS. Lower relative supply should provide positive technical support for TIPS.


Question #7: Is a strategic allocation the only contribution TIPS can make to a portfolio?

Answer: Certainly not. BBH has added performance in conventional bond portfolios with tactical TIPS allocations. Market inefficiencies periodically create trading opportunities that can be exploited by experienced managers like BBH. We may pursue tactical TIPS allocations when:

• Break-even inflation rates are significantly lower than long-term inflation assumptions

• The real yield curve has yet to reflect the shape of the nominal yield curve

• TIPS values do not reflect the seasonality pattern of CPI

• Auction and issuance dynamics create shorter-term technical opportunities

TIPS remain a dynamic active management market.
Question #8: Who should consider TIPS?

Answer: TIPS are particularly attractive for tax-exempt portfolios with large fixed income allocations as they “balance” the fixed income component of a portfolio, muting the effects of shifting inflation on bond returns. The portfolios of central banks, sovereign wealth funds, endowments, foundations and pension funds, unlike taxable portfolios, are not subject to the “phantom income” tax from the accretion of principal that is produced by CPI increases. While episodic, we see an increasing number of diversified capital pools creating dedicated, strategic allocations to TIPS.

Conclusion: Break-even inflation rates of 88 basis points on 10-year TIPS are among the lowest levels since TIPS were first auctioned in 1997. While TIPS prices reflect an expectation for seven years of deflation, we believe unprecedented government stimulus now in place, with more to come, is more likely to normalize (or even accelerate) inflation. Since 1950, rolling 10-year CPI inflation has rarely averaged less than 2%, and has never been less than 1%. The U.S. Treasury’s plan to finance the government's massive new commitments with a disproportionately larger share of nominal Treasuries than TIPS, and the indirect impact of home price effects on the CPI, provide additional support to TIPS values. Moreover, TIPS provide “balance” to fixed income allocations as an asset class that offers important protection when it is most needed — during periods of unanticipated inflation.

This is an extraordinary time to be reviewing the asset allocation properties of TIPS, and we welcome a dialogue on today's unprecedented opportunity set.

1. The CPI is the Consumer Price Index for all urban consumers before seasonal adjustment. The CPI is one of the most widely recognized price measures for tracking the market basket of goods and services purchased by individuals. The weights of its components are based on consumer spending patterns. Source: Bloomberg.

2. The break-even inflation rate is the yield difference between a nominal Treasury and a similar maturity TIPS or the market-implied rate of inflation.

3. Correlation may be higher or lower than 80% in the future due to prevailing market conditions.

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