Wall Street's Great Holiday Sale!

30-Year Treasury Inflation Protected Securities -- TIPS -- are remarkably cheap.

Photo by Alexander Grey on Unsplash

Economics Matters -- Blog/Podcast/Financial Riddler/MaxiFi Puzzler

Help yourself to a free subscription to all four posts at larrykotlikoff.substack.com. I’ll immediately make it a lifetime free subscription. Paid subscriptions come with a one-time, one-hour, free financial consultation with me. Just unsubscribe, resubscribe on a paid basis, and then email kotlikoff@gmail.com to set up a meeting time. Thereafter, just unsubscribe and resubscribe forever for free. Also, please sign up kids, friends, employees, bosses, students, …

When the Price Is Right!

Wall Street is effectively running a fabulous sale on long-term, inflation-protected Treasury bonds. Actually, it’s been running this sale for two years. But the markdown is close to its highest over the period — back to where it was when I penned my prior TIPS epistle.

The yield on 30-year Treasury Inflation Protected Securities (TIPS) is 2.6% per year after inflation. This yield is miles higher than the 1.4% average going back to 2004, when 30-year TIPS were first introduced. The lowest yield, -0.6%, was recorded in March 2020. This means the price of a newly issued 30-year TIPS bond is now running 46 percent below its average price and 66 percent below its highest price. Short-term TIPS are selling at even deeper discounts. The 5-year TIP is yielding 1.4% — far higher than its 0.6% average.

Short of Uncle Sam defaulting — an extremely remote possibility, a $1 million investment today in 30-year TIPS will, if held to maturity, deliver $2.16 million in purchasing power 30 years from now. Well, not quite. TIPS, like other Treasuries, make coupon payments. In fact, these payments comprise 53.7% of the 30-year TIPS value. Thus, how much you’d end up 30 years from purchase were you to reinvest the coupons is uncertain. This said, you can build a TIPS ladder by purchasing TIPS of different maturities and using the principle and coupon payments to cover future real spending needs.

Illustrating a TIPS Ladder Based on a Single TIPS Bond

A simple example is purchasing the 30-year TIP. Buying this bond is equivalent to buying 31 zero-coupon bonds, each yielding 2.6% real. These 31 bonds comprise a) 30 zero-coupon bonds that come due in a different year over the next three decades with each providing a fixed annual real payment of $26,000 (paid in two six-month installments) in the year they come due plus b) a zero-coupon bond that comes due in 30 years and provides a $1 million real payment.

Imagine you’re 70 and have $5 million in assets and annual spending needs (including taxes), after Social Security benefits, of $130,000. Then investing your $5 million in 30-year TIPS will let you a) cover all your spending needs and b) leave $5 million to your children even if you make it to 100. If you die sooner, your kids will collect your coupon payments as well. As this podcast makes clear, building more elaborate bond ladders entails buying TIPS of different maturities. But that’s no big deal.

“But,” Wall Street Will Claim, “You Can Earn Far More on the Market”

While the 2.6% real return on 30-year TIPS is historically high, it may seem like chump change compared to investing in the stock market. Over the past century, the S&P has generated an average annual real return of 7.4%. But the 7.4% return is highly risky. Were it for sure, no one would be investing in TIPS, yielding 2.6%.

Yes, there is some weak evidence for mean reversion in the stock market data — high (low) stock returns arising, more often than not, after low (high) stock returns. But mean reversion is unreliable, showing up only in certain periods, arising only in certain stock markets, and holding only for particular measures of stocks being high and low. Perplexity AI provided this summary.

There is statistically detectable mean reversion in certain periods, markets, and ratios, but it is not so strong or stable that one should confidently bank on large contrarian bets solely on the basis of long‑run mean reversion in the broad U.S. index.

Thus stocks aren’t safer in the long run than they are in the short run. This said, if you believe in mean reversion, this would, based on the standard measure of the level of stocks — the P/E ratio, be the time to reduce your stock holdings. The S&P’s P/E ratio is almost twice its trailing average.

Moreover, many financial pundits are suggesting that the super high valuations of the large tech firms signal an imminent and massive market crash. Furthermore, a third of the S&P’s valuation comprises heavily AI-linked firms. But if the pundits could reliably predict the market, they’d be billionaires, not hawking their guesswork. News drives the market and news, by definition, is unpredictable or, as the mean reversion literature indicates, essentially unpredictable.

Moreover, if everyone thought AI was pure hype, the market would already have crashed. Clearly, current LLMs can do extraordinary things and are saving many of us lots of time. It just gave me a great steak tips recipe with no annoying ads. (Actually, not that great — far too much salt. I’m hoping someone will start a restaurant chain called Saltless.)

So far, there is scant evidence that AI is raising the economy’s productivity. A recent MIT study reports that 95% of companies’ AI initiatives are failing. Still, AI seems to have enormous potential, which may explain why TIPS yields are so high. If AI investment is going to be fabulously profitable, stock yields will continue to be extraordinary requiring a higher return on TIPS to induce their purchase.

Hence, one way to think about the unusually high yield on long-term TIPS is that they provide a way to safely lock in today’s AI’s promise without worrying about it going poof. As discussed in more detail here, we don’t know if AI is the second economic coming or an economic footnote compared to, say, the invention of the combustion engine.

While economics can’t predict future market returns, it does tell us to rebalance our portfolios between risky and safe assets when our risky assets disproportionately rise in value. In light of the run up of the market, such rebalancing entails selling stock and buying safer assets, such as Treasuries.

Which Treasuries?

The question is whether you should rebalance your portfolio by buying regular/nominal Treasuries or TIPS, particularly long-term TIPS. Moreover, if you buy TIPS, should you hold them to maturity. One view of safe investing, embedded in MaxFi Planner’s Upside Investing, entails setting a living-standard floor. This involves buying a collection of TIPS of differing maturities — building a TIPS ladder — to assure you have the cash flow in each future year to cover your living-standard floor. MaxiFi’s suggested withdrawals of regular and retirement-account assets are the cash-flows you want to immunize with your TIPS ladders (one for regular assets, one for your retirement account, and one for your spouse/partner’s retirement account).

Upside Investing doesn’t require putting all your assets in a TIPS ladder. On the contrary, It shows you the upside from putting less in TIPS and more in the market. Upside Investing combines a special spending as well as investment strategy. You spend only out of TIPS, treating your stocks as lost until they are sold in future years and converted into TIPS. At that point, you can sustain a higher living-standard floor. This is where the term “upside” comes from. With this combo strategy, you only face the prospect of a higher floor to your living standard. I.e., your living standard can only go up (absent default on domestic bond holders). In so doing, it provides a clear living standard risk-reward tradeoff.

Unlike regular Treasuries, inflation doesn’t erode the real payouts because TIPS coupon and principal payments are indexed to inflation. On the other hand, if you’re holding TIPS in taxable accounts, there’s the risk of higher taxes due to the inflation protection being taxed as ordinary income. I.e., our tax system doesn’t distinguish nominal and real asset income. Holding TIPS in Roth IRAs avoids this issue entirely. Holding them in traditional IRAs mitigates the problem as the extra taxes are deferred.

Regular Treasuries

Many people consider nominal T-Bills and Treasuries to be safe assets. Not so. Over the past five years, the CPI has risen by almost one quarter. Were you to purchase a 30-year nominal Treasury and experience, over the next five years, the same annual inflation we’ve experienced since November 2020, you’d lose a quarter of your purchasing power by the end of this decade. Of course, if you held onto your 30-year Treasury and were inflation, say, to be zero thereafter, you’d end up with more purchasing power 30 years from now than had you purchased 30-year TIPS. In short, nominal bonds are risky assets. They belong in a well diversified portfolio of risky assets. But they should not be considered safe.

The Hidden Risk to Holding Regular T-Bills and Treasuries

Nominal government IOUs appear particularly unattractive based on something the market may not fully appreciate — namely the prospect of our government making money by making money, i.e., by printing it, albeit electronically. I certainly see lots of inflation in our future — far higher than the 2.2% difference between the 2.6% real yield on 30-year TIPS and the 4.8% nominal yield on regular 30-year Treasuries.

My view might be considered inside information. The reason is that I’ve been studying our country’s fiscal condition very carefully of late. I’m not sure what the market is drinking in assessing long-term inflation at 2.2%. But our country is beyond broke. Indeed, it’s in far worse fiscal shape than Italy.

Please read this paper that’s joint with two co-authors, one at the Bank of Italy. Or take a look at this shorter op ed. It’s probably the most important column about US fiscal policy that’s been written in years. But it was rejected by The NY Times, The Wall Street Journal, Barrons, and The Washington Post. Consequently, we have very important news that didn’t make the news. When you read it, ask yourself if it’s more important than learning that Karoline Leavitt, President Trump’s Press Secretary, is pregnant. This was the third-from-the-top story on nytimes.com yesterday.

If Uncle Sam is as broke as I and my co-authors contend, he’ll likely be forced to print the money he needs. Yes, there are other scenarios. AI could make the country hyper productive without eliminating all the jobs of all the people to whom AI seeks to market its services. (To appreciate this unfortunate and, unfortunately, highly probable outcome, please read this.) Or fusion’s development could make energy infinitely available at no cost. If it could be, it will be is the common belief. Count me a skeptic. So far, AI has produced no discernible increases in US productivity. And fusion seems a long way off.

Bottom Line

To summarize. TIPS yields are historically high. The stock market is historically high. Nominal bonds are, arguably, historically risky. All three facts militate toward considering increasing your holding of TIPS. Whether you go whole hog and walk away entirely from risky assets is, of course, your call. For many people, this is their only smart move.

Imagine you invest just in a TIPS ladder and can, on that basis, afford to spend less than you are spending and wish to spend. Then investing in risky assets entails only downside risk to your living standard. Why? If your risky assets do well, you won’t raise your spending. If they do poorly, you’ll have to lower your spending.

A final question about holding TIPS is whether to do so within a mutual fund. If your objective is to secure your future living standard, you need a particular constellation of TIPS — a particular TIPS ladder — not the composition of TIPS that mutual funds hold. Buying a TIPS mutual fund is like buying a basket of oranges today with the goal of baking apple pies at the end of the week. Instead of buying the apples now, holding oranges means you’re betting that the price of oranges will rise relative to the price of apples, letting you sell oranges, buy more apples, and bake more pies at week’s end. But there’s no guarantee that oranges will rise in price relative to apples. The opposite could occur. In short, TIPS mutual funds, like other risky assets, are a threat to maintaining your lifestyle.

---