MorningStar — Feb. 23, 2010 — By Christine Benz

In upcoming installments of The Short Answer, I’ll tackle real reader questions. Here’s a response to a good question that was posted in response to my column about Treasury Inflation-Protected Securities in retiree portfolios. If you’d like me to tackle a question in a future Short Answer column, please send me an e-mail at christine.benz@morningstar.com.

About the Author

Christine Benz is Morningstar’s director of personal finance and author of 30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances and the Morningstar Guide to Mutual Funds: 5-Star Strategies for Success. Follow Christine on Twitter: @christine_benz and on Facebook.

Meet Morningstar’s other investing specialists.

Contact Author | Meet other investing specialists

Q: You noted that TIPS investors might be inclined to take a more tactical approach, adding to them when they appear cheap and lightening up on them when they appear dear. But how would investors go about making those judgments?

A: Just as stock investors can look at statistics such as price/earnings ratios to determine whether a company is overpriced or a bargain, bond investors’ main tool for judging valuations is how a bond’s yield compares with the yield of another bond, usually a Treasury of the same maturity. The differential between the two is often referred to as the spread. For example, you often hear that junk bonds are a buy when the yield differential relative to Treasuries is 8 percentage points, and they’re expensive when the spread is 4 percentage points or less.

For TIPS investors, assessing the pricing is arguably even more straightforward. By comparing the yield of a nominal (namely, non-inflation-adjusted) Treasury bond with the real (namely, inflation-adjusted) yield of a TIPS bond of the same maturity, you can see whether you’re overpaying or underpaying for inflation protection. And if your expectations for inflation are higher than the inflation rate implied by that yield differential, then it’s a good time to buy the TIPS bond rather than the nominal Treasury.

Right now, for example, the yield differential between a nominal Treasury and a TIPS bond maturing in mid-2019 is roughly 2.3%, implying that investors, in aggregate, think that inflation will run about that level during the next decade. But if inflation runs substantially hotter than that, the TIPS investor will be the winner because she will receive an inflation adjustment on her principal, which will translate into a larger dollar payment at maturity as well as higher real yields as she receives coupons during the lifetime of the bond. The owner of the nominal Treasury, by contrast, will see inflation gobble up a higher percentage of the purchasing power of both his interest payments and principal.

Although it’s easy to compare the numbers, conducting this analysis is harder than it sounds, for a couple of key reasons. For starters, successfully predicting the inflation rate is going to be at best an inexact science. It’s also worth noting that the TIPS market, while less liquid than the market for nominal Treasury bonds, is still pretty efficient. So if some yawning mispricing of TIPS does crop up—as was the case in late 2008, when TIPS got very cheap—it is likely to be quickly arbitraged away.

That’s not to say that buying individual TIPS should be off-limits for investors: The securities are pretty liquid and don’t require credit analysis. It does suggest, however, that investors venturing into TIPS should do so for the right reasons: to insulate their portfolios from the long-term ravages of inflation rather than exploiting a short-term opportunity. If exploiting TIPS market inefficiencies is a side goal, I’ll stand by my recommendation of inexpensive, plain-vanilla TIPS funds, such as Vanguard Inflation-Protected Securities (VIPSX), which can take advantage of temporary mispricings of TIPS of varying maturities.