Editor's note: Investors are fond of determining whether to invest in Treasury Inflation-Protected Securities, or TIPS, based on something called the break-even rate. But what is the break-even rate? We asked Zvi Bodie, professor emeritus at Boston University and author of several books including Worry-Free Investing and Risk Less and Prosper More, to explain.
By Zvi Bodie
At my website you can find the term structure of interest rates on conventional Treasuries and TIPS, and the difference between them, which is called the break-even rate of inflation.
Economists would also call it the forward rate of inflation. It consists of the market expected rate of inflation plus a risk premium, but we have no way to separate the two.
The St. Louis Fed tracks the break-even inflation rate on 10-year Treasuries over time here.
The break-even inflation rate represents a measure of expected inflation derived from 10-Year Treasury Constant Maturity Securities and 10-Year Treasury Inflation-Indexed Constant Maturity Securities. The latest value implies what market participants expect inflation to be in the next 10 years, on average.
The break-even inflation rate is a market-based measure of expected inflation. It is the difference between the yield of a nominal bond and an inflation-linked bond of the same maturity. Since investors' money is on the line, they presumably have an interest in pricing inflation correctly.
To put it simply, you calculate the 10-year inflation break-even rate by subtracting the real (after inflation) yield of a 10-year TIPS from the nominal yield of a traditional 10-year Treasury. Right now, that calculation looks like this:
2.39% (nominal yield) - 0.66% (real yield) = 1.73%
The equation shows that investors today are pricing in 1.73% inflation over the next 10 years. This number is shaped by market decisions: Think inflation will be higher than 1.73%? Buy TIPS. Think inflation will be lower than 1.73%? Buy a nominal Treasury.
Buying TIPS is a gamble against inflation expectations, while also providing insurance against unexpected, runaway inflation. If inflation drops to very low levels, the TIPS buyer loses the gamble. If inflation soars higher, the TIPS buyer wins.
By the way, a 10-year inflation break-even rate of 1.73% is, in my opinion, very low, and makes TIPS an attractive investment today. When the 10-year break-even climbs above 2.5%, TIPS are expensive versus nominal Treasuries. When it drops below 2.0%, TIPS are inexpensive.
Remember, the break-even rate measures expectations. It should not be seen as a 'predictor' of actual inflation. Ten-year TIPS have been auctioned since 1997, so we have good data on how 10-year inflation expectations compared to actual 10-year inflation.
In the 11 years of TIPS auctions with completed 10-year maturities, inflation was underestimated in seven of those years, and overestimated in four of those years. The more recent trend -- because of several years of super low inflation -- has been to overestimate inflation.
Back in January 2007, TIPS buyers were getting a gorgeous real yield of 2.45%, but that still ended up being a losing investment versus a nominal Treasury, which was paying 4.76%.
But then consider January, 2009: Investors were expecting 0.28% inflation over the next 10 years -- a remarkably dour number. TIPS were a screaming buy in 2009, yielding 2.25% after inflation versus a nominal yield of 2.52%. But because inflation expectations were so low (and deflation expectations so high), TIPS were shunned by investors.
The seven underestimates average 0.81% under actual inflation. That's a pretty damning number, indicating that investors' inflation expectations are often far from reality. The four overestimates average 0.41% over actual inflation. Still pretty bad, but I think it's clear that the historical trend in TIPS is to underestimate inflation.
Today's inflation break-even rate of 1.73% happens to be almost exactly the rate of the last 10 years, 1.7%, which was the lowest 10-year period in at least 50 years. Investors are looking backward to predict the future.
With real yields rising, five- and 10-year TIPS are beginning to look like attractive investments in 2017. TIPS aren't super bargains they were in 2008 and 2009, but they are looking like an attractive, very safe alternative for an uncertain future.
About the author: Zvi Bodie is a Questrom School of Business professor emeritus of finance, the author or coauthor of several books on personal finance and investing, including The Future of Life Cycle Saving and Investing (Research Foundation Publications, 2007) and Risk Less and Prosper: Your Guide to Safer Investing (Wiley, 2011).