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Language: english
Created: Mon Sep 25 12:32:03 2000
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TENDING TOWARD TIPS
Familiar Topic investment opportunities that such data highlight are
likely to have been arbitraged away. As applied to
Intuitively Appealing. Inflation-linked bonds (ILBs) TIPS, intuition as well as non-intuitive study of TIPS'
are intuitively appealing to investors who frame their essential mechanics tells us that such securities are
goals in inflation-adjusted terms, including most of the indeed highly reliable hedges against high rates of
endowed institutions eligible for TIFF. Given this unanticipated inflation. (Conventional bonds provide
appeal, TIFF monitors closely the global market in a decent hedge against anticipated inflation, as do
ILBs, which came into being when the UK government equities for that matter.) A more challenging but no
introduced inflation-linked gilts almost two decades less important task for thoughtful fiduciaries is to
ago and which received a major boost when Uncle Sam intuit how TIPS might perform during an extended
auctioned the first linked US Treasury obligations in deflation. Why? Because if fiduciaries can convince
January 1997. In anticipation of the latter event, TIFF themselves that TIPS will indeed perform adequately
published an extensive discussion of ILBs in its during an extended deflation (i.e., a period of falling
quarterly report dated June 30, 1996, as well as a prices for goods, services, and -- assumedly --
follow-on discussion three months later. (Both reports
may be obtained via the Publications section of TIFF's
Website, www.tiff.org. TIFF encourages readers who Figure 1: Global ILB Market
are not familiar with the basic mechanics of inflation-
New Zealand $1b 1 issue
linked bonds to peruse these two "primers" before Sweden $12b 7 issues France $11b 2 issues
tackling the higher-level discussion that follows.) At Canada $9b 3 issues Australia $4b 4 issues
this writing, the global ILB market comprises US $107b 7 issues
UK $111b
approximately $254 billion in securities, including 11 issues
$107 billion of Uncle Sam's linked issues, commonly
but unofficially referred to as TIPS (an acronym for
Treasury Inflation Protected Security). (See Figures 1
and 2.) Given its current size, which equals less than
1/10 of the more than $1 trillion in investable wealth
controlled by US-based charities and less than 1/70 of
the market value of publicly traded US stocks, the
TIPS market is both too small and arguably too dull to
capture the imagination of investment bankers or mutual
Total Market Cap = $254 billion
fund mavens. But that does not mean that ILBs in
general and TIPS in particular do not merit serious
consideration by eleemosynary investors. Indeed,
after much careful thought, TIFF's directors concluded Figure 2: US Treasury ILB Market
in September 1999 that TIPS merit a permanent
Market Value Yield at
allocation (5% at present) in the TIFF Multi-Asset Coupon Maturity Outstanding 6/30/00
Fund, and several of the endowed institutions with
which such directors are affiliated have also 3.625% 7/15/2002 $17.8 billion 3.97%
implemented policy allocations to TIPS. 3.375% 1/15/2007 $16.3 billion 4.08%
3.625% 1/15/2008 $17.3 billion 4.09%
Early But Not Hasty. While the TIPS market is older 3.875% 1/15/2009 $16.3 billion 4.08%
and more predictable than some of the Internet-related 4.250% 1/15/2010 $6.5 billion 4.06%
ventures that have induced certain institutions to 3.625% 4/15/2028 $17.0 billion 3.89%
allocate vastly more money to venture capital than to 3.875% 4/15/2029 $15.3 billion 3.89%
TIPS in recent years, TIPS are undeniably a relatively $106.5 billion
immature "asset class." This is offputting to some
Note: As this essay was being formatted for publication, the US Treasury
fiduciaries, especially those who believe that intuition announced that it would auction an additional $5 billion of TIPS on July
should play no role whatsoever in policy formulation. 12. The bonds will mature in 2010, i.e., the auction will essentially re-
TIFF takes a different view, rooted in the empirical open the 2010 TIPS first issued in January 2000 (see fifth row of Figure
fact that if fiduciaries postpone investment choices 2). The additional $5 billion issuance is not reflected in the amounts
above.
until all relevant return data have rolled in, the
Copyright © 2000 by The Investment Fund for Foundations. All rights reserved. This report may not be reproduced or distributed, in whole or part, by any means, without written permission from TIFF.
This document first appeared in the TIFF Commentary dated June 30, 2000 1
TENDING TOWARD TIPS continued
common stocks), then they might prudently do institutions' overall real return goals (inflation plus
something nifty indeed: shift a defined portion of their five or more percent per annum). This is especially
policy portfolios from conventional bonds to inflation- true of high quality inflation-linked bonds (e.g., the US
linked bonds, while simultaneously boosting (via government's Treasury Inflation Protected Securities
further reductions in conventional bond holdings) their or TIPS).
normal or policy allocations to equities or equity
substitutes. The aim of such shifts? To enhance long- Inflationary Bias. The economies of liberal democratic
term returns without increasing portfolio risk, especially regimes have displayed an inflationary bias since the
under extreme conditions. The policy allocations gold standard was repealed (by the UK in the early
alluded to at the close of the preceding paragraph seek 1930s, followed by the US 40 years later). Central
precisely this aim. The fact that historical data do not bankers' anti-inflation biases notwithstanding, the
exist indicating how TIPS might perform during an switch to a pure fiat money standard creates a reasonable
extended deflation does not make such allocations presumption that democratic capitalism will continue
imprudent per se. As the analysis below indicates, to display an inflationary bias due to politicians' (i.e.,
intuition plus careful study of TIPS' inherent mechanics the electorate's) pursuit of the "Ricardian equivalence."
tells us that the worse deflation becomes -- i.e., the As 19th century economist David Ricardo first observed,
more rapidly and materially prices and interest rates taxpayers can pay for government programs through
spiral downward -- the more TIPS purchased at par or one or more of three means -- current taxation,
below will produce returns resembling those produced borrowing, or inflation -- and there is very little
by conventional Treasuries. This counterintuitive difference between the three with respect to their
conclusion spells opportunity for endowed institutions, eventual burden on society (unless agents outside
especially those governed by trustees who assign equal "society" furnish capital via unduly cheap loans).
probabilities to the two disaster scenarios that can Accordingly, over the very long term, inflation is more
befall equity investors: deflation or very high rates of likely than deflation in societies using a fiat money
unanticipated inflation. standard (e.g., the US).
Interesting Opportunity. The following essay seeks to Real Concern. Under the gold standard that prevailed
stimulate further discussion of this opportunity among from the dawn of democratic capitalism through the
trustees and officers of the charities that TIFF seeks to 1930s in Britain and the 1970s in the US, rising
serve. Should such discussion cause governing boards productivity (i.e., increasing prosperity) manifested
to reach the same affirmative conclusion with respect itself in falling nominal prices of basic goods such as
to TIPS that TIFF's board reached last fall, TIFF food and shelter, and in the ease with which consumers
stands ready to help with implementation: TIFF has could redirect a portion of their incomes to "non-
elected to offer an index fund that will invest exclusively essentials." In the current fiat money era, increasing
in US government ILBs, benchmarked against the prosperity is reflected primarily in falling real prices,
Treasury's 10-year inflation-linked security. Detailed and in the steadily growing portion of consumer
information on this new fund's objectives and expenses incomes directed to goods and services that would
may be obtained by phoning TIFF at 804-817-8200. have been deemed "non-essential" by our forebears.
However, because the nominal money supply continues
to expand, this decline in real prices (and associated
Basic Facts1 increase in living standards) unfolds behind a veil of
rising nominal prices. Judging from today's lofty
No Panacea. As a form of creditorship rather than stock valuations (on broad, cap-weighted US stock
ownership, inflation-linked bonds provide expected indices), the "market" clearly "sees through" the veil
returns below those needed to satisfy most endowed -- indeed, the "market" assumes that productivity will
continue to soar and that the real price of goods and
services will continue to fall at a measured pace. What
1 This section incorporates concepts described in greater detail in The
if it is wrong?
Handbook of Inflation Indexed Bonds, edited by John Brynjolfsson and
Frank J. Fabozzi (New Hope, PA: Fabozzi Associates, 1999), especially
the fine essay therein entitled "Inflation Hedging in a Low-Inflation
World: The Plan Sponsor's Rationale" by Laurence B. Siegel of The Ford
Foundation.
Copyright © 2000 by The Investment Fund for Foundations. All rights reserved. This report may not be reproduced or distributed, in whole or part, by any means, without written permission from TIFF.
2 June 30, 2000 Commentary
TENDING TOWARD TIPS continued
Hedging against Disaster inflation [see (1) above] and provide a "real yield" [(3)
above] but do not provide an "inflation risk premium"
Troubling Scenarios. The "market's" sanguine outlook [(2) above]. Accordingly, when bought and held on a
respecting future price trends could prove materially permanent and passive basis, the nominal bonds of a
wrong in one of two directions -- real prices could very high quality issuer such as Uncle Sam can logically
plummet (severe deflation) or they could soar (severe be expected to outperform inflation-linked bonds
inflation). Either scenario would be damaging if not from the same issuer that are bought and held on the
disastrous for unhedged holders of US stocks (and same basis by the amount of the "inflation risk
perhaps other equities) purchased at today's prices. premium" that the former generate. Putting the same
What to do? point differently, the US Treasury is correct to argue
(as it very conspicuously did when introducing TIPS in
Tradition. Traditionally, endowed institutions have 1997) that Uncle Sam's long-term borrowing costs
hedged against severe declines in equity prices by will be reduced by issuing inflation-indexed bonds
holding conventional bonds (so-called nominal bonds) rather than conventional bonds -- provided, of course,
as a deflation hedge and real estate or resource-related that the Federal Reserve keeps inflation at levels equal
assets (including commodities) as an inflation hedge. to or below investors' ex ante expectations.
Whether real estate, commodities, and other resource-
related holdings constitute a more cost-effective hedge Offputting? The assumed long-term underperformance
against very high rates of unanticipated inflation than of inflation-linked bonds is offputting on its face, but
inflation-linked bonds lies beyond the scope of this if return maximization were prudent fiduciaries' sole
paper. Our chief question here is not whether these goal then we would not be discussing bonds at all,
alternative "inflation hedges" are more choiceworthy whether nominal or inflation-linked. We are discussing
than inflation-linked bonds but whether endowed such assets because our assumed risk tolerance is such
institutions can safely rely on inflation-linked bonds as that we cannot withstand the volatility associated with
their primary "disaster hedge," i.e., whether they can an all-equity portfolio. Just because nominal bonds
prudently divide their investable assets between equities can logically be expected to produce higher returns
broadly defined (including equity substitutes such as than inflation-linked bonds does not mean that nominal
absolute return-oriented strategies) and inflation-linked bonds deserve a permanent place in endowment
bonds and reduce if not eliminate altogether their portfolios. Our aim is to determine which mix of assets
conventional (a/k/a nominal) bond holdings. provides the highest long-term returns that are
consistent with specified risk tolerances, and it is
Conventional Bond Mechanics. The chief argument entirely possible that the distinctive attributes of
against such a policy (jettisoning conventional or inflation-linked bonds cause portfolios that comprise
nominal bonds in favor of inflation-linked bonds as an only equities broadly defined plus inflation-linked
all-purpose hedge) is rooted in a consideration of bond bonds to dominate portfolios that comprise these two
mechanics, i.e., what makes bonds "tick." Returns on asset classes plus conventional bonds. To validate this
conventional bonds can usefully be subdivided into claim, we need to do more than simply peek "beneath
three parts: (1) income or accretion of market value the hood" of each type of high quality bond that we
that compensates holders for current inflation, (2) might consider holding for disaster hedging purposes
income or accretion that compensates holders for -- we need to climb right into the engines themselves
expected future inflation (the so-called "inflation risk and better understand what makes them tick.
premium"), and (3) income or accretion that
compensates holders for deferring consumption, a/k/a
"real yield." As we shall see, "real yields" are anything Inside the Engine
but stable because they are tied directly to society's
ever-changing willingness to defer consumption in Different Engines. As noted previously, bond returns
favor of investment, i.e., to what market historians call can usefully be subdivided into discreet parts, with
"changing animal spirits." nominal bonds having a "three-cylinder engine" and
inflation-linked bonds having a "two-cylinder engine."
Peering beneath the Hood. Returns on inflation- The first "cylinder" is the return that compensates
linked bonds have not three but rather just two investors for current inflation; the second is the return
subcomponents: they compensate holders for current that compensates them for unknown future inflation;
Copyright © 2000 by The Investment Fund for Foundations. All rights reserved. This report may not be reproduced or distributed, in whole or part, by any means, without written permission from TIFF.
Commentary June 30, 2000 3
TENDING TOWARD TIPS continued
and the third is the return that compensates them for the other direction -- away from near-term
deferring consumption, also known as "real yield." consumption in favor of long-term investment -- and
Importantly, both conventional bonds and inflation- you elect to jump aboard the same bandwagon, then
linked bonds are affected (indeed, identically affected) your expected "real yield" will be reduced. An observer
by changes in real yields: as real yields rise, the market monitoring your behavior would say, logically, that
value of both types of bonds will tend to fall and vice your required "real yield" has dropped that you are
versa. incrementally willing to defer consumption.
Real Yields. What is a "real yield" and why is it so Unique Asset. There are lots of ways you can defer
important to the policy issue we're attempting to consumption: Wall Street is very inventive. You can
resolve here -- whether to jettison nominal bonds in buy nominal bonds, stocks, other investments -- or
favor of inflation-linked bonds? We have already inflation-linked bonds. The difference between the
advanced one definition of real yield: it is the former types of investments and inflation-linked bonds
compensation that investors demand for deferring -- and it is a profound difference indeed -- is that the
consumption in favor of investment. Looked at another real or inflation-adjusted return that you will receive
way, the prevailing real yield in an economy is a on inflation-linked bonds held to maturity is known
measure of investors' collective judgment about the ahead of time. This is untrue of any other type of
real or inflation-adjusted rate at which the economy investment, and it is such a profound difference that
can be expected to grow, i.e., the rate at which living economists (including Mr. Greenspan) ascribe acute
standards are expected to improve. Ask yourself this importance to the price behavior of inflation-linked
question: if you expect the money in your pocket to bonds: when the price that investors are willing to pay
buy more goods and services in the future than it does for such bonds falls (all else equal), it tells policy-
today, would you not consider deferring consumption makers that investors think they can earn incrementally
so that you can enjoy more things later rather than higher real yields investing elsewhere. In other words,
fewer things today? Assumedly, you would, and the it tells them that investors think there are incrementally
precise balance that you strike between current superior growth opportunities elsewhere in the
consumption and investment determines how much economy, i.e., that the economy's long-term real growth
you yourself will contribute to the overall supply of rate has risen incrementally. Conversely, when the
risk or investment capital in the economy. The more price of inflation-linked bonds rises (all else equal), it
you elect to defer consumption, the more investment tells policy-makers that investors expect incrementally
capital you will supply to the economy, and the more lower real or inflation-adjusted growth in the economy.
capital you supply to the economy, the more you will
bid up the price of financial assets such as stocks and Troubled Infancy. This is not mere conjecture. When
bonds. Of course, as financial asset prices rise, each Uncle Sam first issued TIPS in February 1997, the
marginal dollar that you shift from consumption into price at issue enabled buyers to lock in a real yield of
investment "buys" incrementally less future 3.6%. (The first TIPS issued were 10-year notes.) This
consumption (because you're paying more for the first tranche of TIPS has since fallen slightly in price,
investments in question), and at some point you might boosting the guaranteed real yield to a prospective
decide to stop shifting funds from consumption to buyer from 3.6% to 4.1%. Over the same 41-month
investment and hit the shopping mall. Viewed time period, the S&P 500 has risen 93%, and the
abstractly, the point at which you stop investing and Nasdaq Composite Index (as hairy-chested a measure
start spending determines your required "real yield" of investors' future growth expectations as exists today)
-- the price you demand for saving rather than spending. has risen an even more impressive 189%. Clearly,
Reductio ad absurdum, if most investors suddenly investor expectations respecting the US economy's
elect to favor spending over saving, their combined act future real growth rate have risen since early 1997, and
of cashiering their portfolios in favor of trips to the this increased optimism has manifested itself in their
mall (real or virtual!) will cause financial asset prices decreased willingness to accept the 3.6% guaranteed
to fall. If you buck the crowd rather than join it and buy real return that TIPS provided when the first tranche of
these assets after their price has fallen, then the reward them were issued almost three years ago. Why settle
you receive for deferring consumption will increase, for a derisory 3.6% real return when you have the
i.e., you will be rewarded with a higher "real yield." potential to earn much higher real returns investing in,
Conversely, if investor sentiment swings sharply in say, Cisco or Oracle?
Copyright © 2000 by The Investment Fund for Foundations. All rights reserved. This report may not be reproduced or distributed, in whole or part, by any means, without written permission from TIFF.
4 June 30, 2000 Commentary
TENDING TOWARD TIPS continued
Avoiding Crack-Ups Figure 3: Breakeven Inflation Rates
Needless Insurance? Clearly, if one assumes that the TIP TIP Breakeven
Maturity Real Inflation
economy will grow indefinitely at the same consistently
Date Yield Rate*
high inflation-adjusted rate that it has in recent years,
there is no reason to own any assets other than common 7/15/2002 3.97% 2.42%
stocks. Indeed, some investors appear to have reached 1/15/2007 4.08% 2.14%
precisely this conclusion and have moved to an all- 1/15/2008 4.09% 2.11%
equity posture. The risk they run is that the economy 1/15/2009 4.08% 2.08%
will grow at a slower or more erratic inflation-adjusted 1/15/2010 4.06% 1.96%
pace, for one of two reasons: the actual volume of 4/15/2028 3.89% 2.23%
goods and services produced by the economy could 4/15/2029 3.89% 2.20%
fluctuate materially, causing real growth to vary * TIPS yield less yield of comparable maturity nominal Treasury.
materially even if price levels stay relatively flat, or Source: Bloomberg.
nominal prices (i.e., inflation) could change at an
unexpectedly rapid rate, causing real or inflation-
adjusted GDP growth to vary from ex ante assumptions 4.06%. (See fifth row of Figure 3.) The difference of
even if tangible output stays relatively flat. Of course, 1.96% is referred to as the conventional note's "inflation
both variables (actual output and nominal prices) risk premium" and is also known as the "breakeven
could fluctuate more than investors assume they will, rate of inflation" for 10-year Treasury paper. In other
and if both determinants of real GDP growth swing to words, a tax-exempt investor who thinks inflation will
unanticipated extremes simultaneously, economic average 1.96% over the next 10 years should essentially
turmoil if not disaster could ensue. be indifferent between the two instruments just
described. [TIPS are structured in a manner that makes
Parade of Horribles. In general, such disaster could them suitable primarily for tax-exempt investors,
take one of two forms: a major deflation such as that including individuals investing through IRAs or 401(k)
which the world endured in the 1930s and Japan has plans.] If, by chance, the economy slides into a
endured in the 1990s or a major inflation such as that decade-long deflation and inflation averages far less
which Germany endured in the 1920s and much of the than 1.96% per year through 2010, then investors who
developed world endured in the 1970s. History teaches purchase the Treasury's nominal bonds of 2010 rather
us that stocks will perform very poorly under both than its TIPS will pocket the 1.96% per annum inflation
scenarios -- poorly enough that endowed institutions risk premium.
with finite tolerances for falling endowment income or
capital values may need to hedge against such disasters. Nice Kicker. Importantly, due to the magic of
Conventional Treasury bonds are a better deflation compounding and the way in which interest payments
hedge than TIPS. Why? Because as previously noted on TIPS are computed, investors who hold nominal
the attribute that distinguishes the two is that Treasuries rather than TIPS in our example will actually
conventional or nominal Treasuries embody an inflation earn incremental returns exceeding 1.96% per annum
risk premium, thereby virtually guaranteeing that for the 10 years in question. Not only that: in addition
conventional Treasuries will outperform inflation- to arriving at a different and more attractive destination
linked bonds of comparable maturity if inflation is in 2010, holders of conventional Treasuries will likely
unexpectedly low, as would be true under deflationary have a more pleasant ride en route because the bonds
conditions. they hold are less susceptible to an interim sell-off
caused by investors' need to sell bonds to offset
Basic Math. How does one measure this inflation risk deflation-induced declines in stock dividends (or to
premium? It is simply the difference between the meet margin calls!).2
yield-to-maturity on a conventional Treasury obligation
and the guaranteed real yield on a Treasury linker with 2 But note that under all scenarios excepting deflation, TIPS tend to
the same maturity. For example, at this writing, a 10- display less downside volatility than conventional bonds of comparable
year Treasury note due in 2010 has a yield-to-maturity maturity. This is because TIPS' structure shields their holders from the
of 6.02%; the corresponding real yield on an inflation- principal source of downward volatility of conventional bonds, namely an
increase in the rate of expected future inflation. As previously noted,
linked Treasury maturing at about the same time is TIPS are sensitive not to changes in expected future inflation but to
Copyright © 2000 by The Investment Fund for Foundations. All rights reserved. This report may not be reproduced or distributed, in whole or part, by any means, without written permission from TIFF.
Commentary June 30, 2000 5
TENDING TOWARD TIPS continued
Figure 4: Deflation Scenario How to Choose? Given the facts just presented, how
Cash Flows on 10-Year TIPS can thoughtful trustees choose between conventional
bonds and inflation-linked bonds for disaster hedging
Semi- Infla- Inflation- Inflation- purposes? The answer would appear to turn on whether
Annual tion Adjusted Nominal Adjusted
Period Index Principal Cash Flow Cash Flow
they think deflation or severe inflation is more probable
because conventional bonds perform best under the
0 100 $100,000 ($100,000) ($100,000) former condition and inflation-linked bonds perform
1 99 99,000 1,980 2,000 best under the latter. In fact, most experienced
2 98 98,000 1,960 2,000 fiduciaries (including TIFF's officers and directors)
3 97 97,000 1,940 2,000 are unwilling to place large bets on their own or anyone
4 96 96,000 1,920 2,000
else's ability to forecast accurately such probabilities.
5 95 95,000 1,900 2,000
6 94 94,000 1,880 2,000
Accordingly, they end up owning both conventional
7 93 93,000 1,860 2,000 bonds and some sort of "inflation hedge," with inflation-
8 92 92,000 1,840 2,000 linked bonds appearing in many "state-of-the-art"
9 91 91,000 1,820 2,000 portfolios and with more and more institutions adding
10 90 90,000 1,800 2,000 them to their policy mixes with each passing day. The
11 89 89,000 1,780 2,000 question before the house is whether it makes sense to
12 88 88,000 1,760 2,000 own both conventional bonds and inflation-linked
13 87 87,000 1,740 2,000 bonds or whether the former can safely be excised
14 86 86,000 1,720 2,000 from long-term policy portfolios (even if they are
15 85 85,000 1,700 2,000 sometimes held for strategic or tactical purposes).
16 84 84,000 1,680 2,000
17 83 83,000 1,660 2,000
Sharper Point. To put a sharper point on the problem,
18 82 82,000 1,640 2,000
19 81 81,000 1,620 2,000 the question we seek to answer is whether the
20 80 80,000 101,600 127,000 advantages of holding TIPS rather than a combination
of TIPS and conventional bonds during inflationary
Annualized IRR 3.6% 6.0% shocks outweigh the disadvantages of pursuing this
Note: Assumes 2% coupon paid every six months on 10-year TIPS with policy when deflation rears its ugly head. To answer
actual inflation of -1% every six months. Semi-annual coupon on TIPS this question, we need to explore more fully how both
is based on original principal adjusted for deflation. types of bonds (as well as equities) might be expected
to perform in abnormal economic environments. Alas,
Swift Kick. But what if the opposite scenario unfolds the phenomena we seek to explore are less monolithic
and the economy undergoes a major inflation? Clearly, than they appear: as with cholesterol, there is "good
TIPS are a better hedge against this scenario than deflation" as well as "bad deflation" and "good" as
conventional Treasuries -- indeed, under any scenario well as "bad" inflation.
entailing inflation that exceeds the "breakeven rate" at
the time TIPS rather than conventional Treasuries are
purchased for inflation-hedging purposes. Moreover, Going Downhill
just as the incremental total return on conventional
Treasuries is unexpectedly large (in relation to the Good Deflation. Deflation is synonymous with falling
"breakeven rate") under deflationary scenarios, so too prices -- nominal prices, that is.3 "Good deflation"
is the incremental total return on TIPS under inflationary occurs when nominal prices fall but the actual output
scenarios. Again, this surprising but by no means of goods and services (i.e., the number of cars,
counterintuitive result is rooted in both the magic of refrigerators, ice cream cones, plane rides, etc. actually
compounding and the peculiar way in which Uncle
Sam computes interest on TIPS.
3A nominal price is what appears on the price tag. Laypersons lacking
PhDs in economics education can be excused if they confuse nominal
changes in required real yields, which tend to be 1/3 to 1/2 as volatile as prices with so-called "real prices," which are nominal prices adjusted by
changes in required nominal yields. In other words, the deflation "hedge" cumulative inflation since a specified inception date. You'd think that
imbedded in TIPS asymmetrically skews their expected returns relative to economists would have the decency to call the prices actually paid at the
conventional Treasuries: TIPS' expected outperformance during checkout counter "real prices," but they prefer to call these "nominal
inflationary conditions sharply exceeds their expected underperformance prices," reserving the term "real" for prices that are inflation-adjusted. In
during deflationary conditions, an attribute highlighted by Figure 5. other words, "real" and "inflation-adjusted" are synonymous.
Copyright © 2000 by The Investment Fund for Foundations. All rights reserved. This report may not be reproduced or distributed, in whole or part, by any means, without written permission from TIFF.
6 June 30, 2000 Commentary
TENDING TOWARD TIPS continued
produced and purchased) does not. It might seem silly initial investment of $1 million, this return differential
to think that economic conditions could ever be so would have produced a stunning $1 million difference
benign, but there have been numerous intervals of in terminal wealth by the time consumer prices stopped
"good deflation" in the history of democratic capitalism, falling in mid-1933 ($1.15 million bond portfolio
as can be inferred from historical stock returns: during versus $112,750 stock portfolio). Alas, investors
the 32 years since 1790 that US consumer prices have cannot know how inflation-linked US Treasury
fallen at the rate of more than 4% per annum, US stocks obligations performed during the 1930s, because such
have generated an average annual return of 11.3%.4 securities were first issued in 1997. Nor do we know
how inflation-linked bonds performed during Japan's
Happy Days. There is no reason to think that we will "bad deflation" of the 1990s because the Japanese
not enjoy such happy circumstances again. (Indeed, government has issued only conventional bonds to
some skeptics would assert that the lofty levels at date. We do know that Japanese stocks performed
which some US stocks are trading today are very poorly in the decade just ended, with the widely
unreasonably high unless "good deflation" is just followed Nikkei 225 index producing an average annual
around the corner). Clearly, inflation-linked bonds are compound return of 6.9% (in yen terms) for the 10
suboptimal investments during "good deflations": years ending December 31, 1999, during which time
stocks can be expected to perform surprisingly well (as Japan's equivalent of the CPI rose just 1.1% per year
indicated by the historical returns cited in the preceding on average with two years exhibiting outright deflation.
paragraph), and conventional bonds can be expected to (Exclude 1999, which was a good year for Japanese
outperform inflation-linked bonds of the same maturity stocks, and the Nikkei's compound return falls from
(due to conventional bonds' unique inclusion of an 6.9% for 10 years to 10.8% for the nine years ending
inflation risk premium). December 31, 1998.) Not surprisingly, conventional
bonds vastly outperformed stocks in Japan in the
Bad Deflation. "Bad deflation," on the other hand, is 1990s, with the Japan component of the J.P. Morgan
a prospect much to be feared. Characterized by Government Bond Index producing an average annual
dramatically waning "animal spirits" (i.e., business compound return of 6.8% (in yen terms), about 14%
confidence), "bad deflation" can be as nasty and as better per year than equities. On an initial investment
self-reinforcing as its polar opposite (hyperinflation). of $1 million, this return differential would have
As people facing shrinking incomes curtail their produced a staggering $1.44 million difference in
manufacture or purchase of goods and services for fear terminal wealth by the end of the decade ($1.93 million
of getting caught short, others with whom they might bond portfolio versus $487,000 stock portfolio).
have transacted also ratchet down their buying,
reinforcing both downward pricing pressures and
shrinking output. As the experiences of the US circa Floor It
1930s and Japan circa 1990s suggest, stocks tend to
perform poorly during "bad deflations." During the Startling Inferences. Although there are no historical
most severe bout of "bad deflation" that the US economy data on which we might base forecasts of inflation-
has undergone, inflation averaged 9.2% and US stocks linked bond returns during periods of "bad deflation,"
(as measured by the S&P 500) generated an average careful study of the manner in which the US
annual compound return of 44.9%. (These data government's inflation-linked bonds have been
reflect CPI inflation and the total return on the S&P structured produces some interesting if not startling
500 from October 1, 1929, through May 31, 1933.) surmises about their likely behavior during such
Over the same 44 month period, an index of the periods. To the extent that such inferences prove
relatively small (by post-WW II standards) amount of startling, it is usually because those being startled have
US government bonds then-outstanding generated an overlooked or given short shrift to the crucial fact that
average annual compound return of 4.0%.5 On an Uncle Sam's TIPS (or sovereign credits of comparable
quality with TIPS-like contractual terms) are guaranteed
4 Ibbotson and Brinson, quoted in Brynjolfsson and Fabozzi at page 66. to return par at maturity, with par (i.e., $1.00 for each
Note also that in 1999, Hong Kong stocks (as measured by the MSCI Hong $1.00 of face value) defined in nominal terms.
Kong Index) returned 66%, which translated into a 70% inflation-
adjusted return. Hong Kong's CPI actually fell by 4% in 1999 -- a vivid
Differently put, some folks are floored to learn that the
recent example of "good deflation." floor underlying such securities is as high as it is. To
5 Source: Global Financial Data. be sure, TIPS and other comparably structured inflation-
Copyright © 2000 by The Investment Fund for Foundations. All rights reserved. This report may not be reproduced or distributed, in whole or part, by any means, without written permission from TIFF.
Commentary June 30, 2000 7
TENDING TOWARD TIPS continued
linked bonds provide their holders with periodic that capital values alone will take if and when disaster
interest payments that can decline in nominal terms if strikes. This is by no means the sole or even chief
the price index to which such bonds are "linked" drawback of such models. Indeed, as the two-part
actually falls. (See Figure 4 for an illustration of what monograph on asset allocation that TIFF published in
happens to cash flows on TIPS held during an extended 1999 makes plain,6 computer-based models provide
deflation.) As Figure 4 indicates, an investor who buys little if no help to trustees seeking to unlock the puzzle
one of Uncle Sam's inflation-linked bonds at par with with which we're wrestling, because the puzzle's key
a guaranteed real yield of 4% will not necessarily "lies within."
receive $4,000 per year for every $100,000 he invests.
The bond's actual yield could fall below $4,000 per Risk Is in the Eyes of the Beholder. More specifically,
annum if the annual recalibration of the bond's indexed to determine whether and to what extent conventional
value causes this amount to fall below the original bonds should be jettisoned in favor of inflation-linked
$100. But the pain caused by income payments whose bonds for hedging purposes, trustees must first specify
nominal value is less than what an investor expected to with reasonable precision which forms of risk they are
earn based on the real yield his broker quoted when the most interested in controlling: (1) cash flow shortfalls,
inflation-linked bonds were purchased is at least (2) interim absolute losses, (3) interim shortfalls relative
partially mitigated by the enhanced purchasing power to peer institutions' results, or (4) some other measure(s)
of his principal when the bond matures (see right-hand of risk. The analysis that follows assumes that the first
column of Figure 4). The key point to note is that US two forms of risk are very important while the others
inflation-linked bonds (as well as those issued by are not, i.e., it assumes that trustees who have read this
France, Sweden, and certain other countries) have a far are interested in a "non-political" or "non-
"deflation floor" whereby holders are guaranteed a behavioral" answer to the question before the house.
return of principal in nominal terms when these To repeat, the question before the house is whether
securities mature. trustees can prudently jettison conventional bonds in
favor of inflation-linked bonds as their endowed
Bumpy Ride? What about interim losses? This is of institutions' primary hedge against big problems
profound importance to endowed institutions for two (shrinking current yields or market values or both) in
reasons. First, many employ spending rules tied to the the total return segments of their portfolios. Trustees
market values of their overall portfolios, and they do who are unduly concerned about "embarrassments"
not want assets held for hedging purposes to decline cannot act upon the analysis that follows, because it
materially in price at the same time that assets held for ignores the third form of risk identified immediately
total return purposes (i.e., equities broadly defined) above ("interim losses relative to peer institutions'
are undergoing a deflation-induced collapse. Second, results").
quite apart from interim capital losses and the big dips
in formula-driven endowment withdrawals that they Getting to Yes. TIPS' attributes are such that one
can spawn, the last thing perpetual life institutions doesn't need a huge percentage allocation to them to
want is to engage in the forced sale of long-term keep overall endowment peak-to-trough losses to
holdings at temporarily depressed prices -- something tolerable levels under extreme inflationary conditions.
they will have great difficulty avoiding if their Under such conditions, of course, it is hugely helpful
"hedging" assets as well as their total return assets are to maintain de minimis or zero exposure to conventional
undergoing a general sell-off when bills must be paid. deflation-hedging bonds, i.e., one can adopt a higher
policy allocation to so-called total return assets (equities
Where's the Beef? The chief if not sole virtue of using and equity substitutes) precisely because the mix entails
conventional Treasuries rather than TIPS to hedge an abnormally low allocation to conventional bonds.
against deflation is that the former can be expected to Turning to the opposite disaster scenario -- deflation
appreciate during an extended deflation, making them -- one must simply ask whether the maximum prudent