Forget Gold — Buy TIPS for a True Safe Haven

by Dan Burrows | April 16, 2013 1:26 pm

Anyone holding gold as a safe-haven asset and hedge against inflation should feel doubly stupid today.

Not only has the precious metal just suffered a price drop of historic proportions[1] (so much for safety), but there’s no inflation either.

The Federal Reserve and central banks throughout the world are force-feeding the financial system with liquidity, and yet consumer prices in the U.S. actually dropped last month.

Meanwhile, anyone holding Treasury Inflation-Protected Securities (TIPS) to maturity has been able to sleep soundly through the rush from gold and the latest deflationary figures.

Why? Because holders of TIPS know with almost 100% certainty that they’re going to get their principal back. And if inflation does eventually pick up — and we should all hope that it does, frankly — they’re covered in that event too.

Seasonally adjusted U.S. consumer prices fell 0.2% last month due mainly to lower prices for gasoline and energy. Economists were looking for a 0.1% decline. Core prices, which exclude volatile food and energy prices and are used by the Fed as a more reliable measure price trends, rose just 0.1%. Economists expected core prices to rise 0.2%.

And so here we are: Despite years of dire warnings on the part of the gold bugs, the firehose of central bank liquidity hasn’t led to anything close to serious inflation — to say nothing of hyperinflation. Get this: Core consumer prices have risen at an average annual rate of about 1.6% since 2008.

How low is that? It’s so low the Fed has set an inflation target of 2%. The central bank is actually struggling to get prices to rise at that meager pace. And even then, inflation would still be well below the U.S. long-term average of more than 3%.

Which is where TIPS come in.

Unlike gold, they really are as close to a safe haven and inflation hedge as you can get. Indeed, many financial advisers consider TIPS to be the safest investment there is.

That’s because TIPS have a unique property that fixed-income investors love. They’re Treasury bonds backed by the full faith and credit of the U.S. government, but twice a year their principal, or face value, moves 1-to-1 with inflation as measured by CPI (on a non-seasonally-adjusted basis).

Even if inflation is nowhere in sight now, it will come back eventually. (We should certainly hope that it does to some small degree, since it would signal that the economy is growing more rapidly.)

When prices do start rising faster then they are now, you’ll be glad to have some of your retirement portfolio allocated to TIPS.  After all, as tame as 3% inflation may sound, it adds up over the long run. Heck, at the average long-term inflation rate of 3.23%, prices double every 20 years.

That’s why TIPS make sense for retirement accounts despite the lack of inflation and their negative yields.

As crazy as it sounds, buyers of TIPS have actually been paying the Federal government for the privilege of owning this debt. In the most recent Treasury auction, TIPS sold for an effective yield of -0.6%.

But there’s a method to this seeming madness. Not only is the principal all but assured (the government has both a massive tax base and a printing press to make good on its obligations), but TIPS would actually outperform benchmark government debt if inflation returned to more normal levels.

Mihir Worah, a managing director and portfolio manager at Pimco, once gave this hypothetical example illustrating how a current negative yield on TIPS would deliver better returns than a benchmark 10-year Treasury with a higher yield:

“If inflation for the next 10 years averages 3% and the nominal (non-inflation-adjusted) 10-year Treasury yield is 2%, then the real return on nominal 10-year Treasuries could end up being -1%, significantly lower than that offered by comparable maturity TIPS.”

There might be no sign of inflation now, but over the next 10 years? That’s something you need to be mindful of in your retirement planning. And you can’t count on gold to protect your nest egg.

Historically, gold prices have been plenty volatile[2]. On an inflation-adjusted basis, an ounce of the precious metal went from about $1,600 in 1980 to $600 by 1990 to $400 at the turn of the millennium.

Hold 10-year TIPS to maturity and you get your principal back, plus the inflation adjustment, plus interest. No, you won’t get rich, but you will get your money back with a smidgen of total return … and probably a better night’s sleep, too.

As of this writing, Dan Burrows did not hold any of the aforementioned securities.

  1. price drop of historic proportions:
  2. gold prices have been plenty volatile:

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