Inflation-Spooked Investors Run for Cover

10/29/2010 10:25 am EST

Focus: BONDS

Jim Jubak

Founder and Editor, JubakPicks.com

Some investors are so scared of rising prices that they've gobbled up inflation-protected Treasurys at a loss just for safety. That bodes well for high-yield stocks.

This week, investors bought $10 billion in Treasury inflation-protected securities— and paid for the privilege of lending the federal government money.

Investors paid $105 for each $100 in face value. That reduced the yield on these bonds to a negative 0.55%.

These investors weren't insane. Just very, very afraid of inflation.

That fear doesn't tell you much about when inflation will pick up or how high the inflation rate will go. But that fear—and investors' willingness to accept a negative yield to make things a little less scary—does tell you that despite the big increase in the prices of hedges against inflation, tangible things like oil, copper, tin, and fertilizer are going to get pricier.

How TIPS Work

Treasury inflation-protected securities, or TIPS, don't pay interest like regular Treasury bills, notes, and bonds, and they don't return principal at maturity the way that regular Treasury bonds do.

TIPS do come with a coupon yield, just like any other bond. The coupon on the TIPS sold this week was for interest of 0.5%. Positive interest, if only a very little of it. It was the bidding of investors at the Treasury auction that pushed the price of a $100 bond to $105. And that took the interest rate into negative territory.

The yield on a regular five-year Treasury note is 1.31%. So why was there so much demand that this $10 billion in TIPS paying only a coupon of 0.5% wound up selling for $1.05 on the dollar?

Because, unlike regular Treasury issues, where rising prices can destroy the value of interest payments and principal, TIPS offer a promise of protection against inflation.

At the end of five years, owners of regular five-year Treasurys get their principal back. But how much is that principal worth in real buying power if the prices of everything you want to buy have been rising every year because of inflation?

The Inflation Calculation

Let's say inflation runs at a 3% rate during the five-year life of a regular Treasury note. At the end of one year, $100 in principal has the buying power of just $97 because the prices of those things you want to purchase have climbed 3%. The next year, your principal is worth just $94.09. The year after that, $91.27. Then $88.53 and $85.87.

You may get $100 in cash back when that Treasury matures, but in buying power, you've taken a 14.13% loss on your principal.

Yes, you get paid interest while you wait. But at the current interest rate of 1.31% on five-year Treasurys, you can't hope to make back that 14.13% loss on the real value of your principal from interest payments—especially because the real value of those interest payments is also declining because of inflation. At 1.31%, your five-year Treasury isn't generating much income, but with 3% inflation, the $1.31 that each $100 of Treasury generates is worth four cents less after one year. And so on.

The principal of a TIPS bond and its interest payments, on the other hand, are protected from inflation. (Well, inflation at the official rate, anyway.)

At the end of five years, when the shortest-duration TIPS mature, the value of the principal is increased to reflect the rate of inflation. (The inflation benchmark is the rate of increase in the Consumer Price Index over the previous six years.) Interest payments, too, are indexed to the inflation rate.

To give you an example from the Treasury's Web site of how this works: At maturity in January 2009, $1,000 in a ten-year TIPS bond with a coupon of 3.875% would generate $50.84 in interest—considerably more than the $38.75 coupon yield, thanks to the TIPS inflation adjustment—and a $309.14 gain to principal from the inflation adjustment.

TIPS aren't perfect inflation hedges. The inflation adjustment is based on the past six years, so it can lag if inflation suddenly shoots up. And for all their wrinkles, TIPS are still bonds, which means buyers face typical bond problems, such as where to reinvest those interest payments.

But they aren't a bad inflation hedge at the right price.

NEXT: So How Do You Judge What's the Right Price?

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Paying Protection Money

How do you judge what's the right price? By something called the break-even inflation rate. You calculate this number by subtracting the yield on TIPS from the yield on the equivalent plain-vanilla Treasurys. The difference tells you the average annualized inflation rate that a TIPS buyer has to see before the total TIPS package of interest payments and inflation adjustments to principal and interest matches the higher interest payments on plain-vanilla Treasurys.

So this week's auction of TIPS showed a break-even inflation rate of 1.31% (the interest rate on plain-vanilla five-year Treasurys) minus the negative-0.55% yield on TIPS, for a break-even inflation rate of 1.86%.

That's not such a big reach from the current annual Consumer Price Index rise of 1.1% (as of September). Of course, in percentage terms, that 0.76-percentage-point move represents a 69% increase.

But the big question is how long it takes inflation to reach that break-even rate of 1.86%. Remember, that's an annualized average for the period, so the longer it takes inflation to get started, the higher inflation will have to be by the latter years of our five-year period.

I think TIPS are a decent investment right now. Inflation will be higher five years from now, so the inflation protection in TIPS will be valuable. And, if in that period the Federal Reserve succeeds in using a new program of quantitative easing to drive down medium-term interest rates, then the 0.5% coupon rate on TIPS will be more attractive and the price of the bonds will climb. The combination of expectations for rising inflation and lower interest rates makes TIPS attractive—especially because we know that if inflation does rise, the price of TIPS will, too. (As I wrote this week in "Ten Ways to Survive a Zombie Economy," hedges are cheaper when the zombie in question—inflation—is distant.)

What All This Means for Stocks

But what's interesting to me as an investor in stocks—I don't do bonds or windows—is the conviction that inflation is enough of a danger that it's now worth buying TIPS at a negative yield.

To me, if investors are willing to take on a negative yield to protect their principal from inflation, then inflation hedges that offer a higher yield and the chance for capital appreciation greater than the rate of inflation should still have a pretty good run ahead of them.

So, how attractive is an oil company stock such as Statoil (NYSE: STO) that has the potential to add to reserves from new finds in the North Atlantic and Arctic waters (that's the capital-appreciation part) and that shows a projected yield, according to Morningstar, of 3.6%? (Morningstar's projected yield is lower than the current 4.2% trailing yield because Morningstar isn't counting on the repeat of the company's special cash dividend in May 2009.) Norway, a country with one of the world's strongest currencies.

Or how about Southern Copper (NYSE: SCCO), with its 3.5% projected yield and its reserves of copper?

And think about Newmont Mining (NYSE: NEM) in this light. The company mines gold, a decent inflation hedge, and pays a 1.01% dividend. That's not enough to get this stock into my Dividend Income Portfolio, but it sure beats the negative 0.55% yield on five-year TIPS.

One caution: Right now, the stock market looks—and I say looks—like it wants to take some of the gains since August out of commodity stocks like these. I'd give the market a bit of time here to see whether prices drop a bit.

At the time of publication, Jim Jubak's personal portfolio did not include shares of any company mentioned in this column. The mutual fund he manages, Jubak Global Equity Fund (JUBAX), may or may not now own positions in any company mentioned in this column. As of the end of September, the fund owned shares of Statoil, Southern Copper and Newmont Mining. You should not assume that the fund still owns positions in those stocks. For a full list of the stocks in the fund as of the end of the most recent quarter, see the fund's portfolio here.

Jim Jubak has been writing "Jubak's Journal" and tracking the performance of his market-beating Jubak's Picks portfolio since 1997 on MSN Money. He is the author of a new book, The Jubak Picks, and he writes the Jubak Picks blog. He is also the senior markets editor at MoneyShow.com.

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