Slam-Dunk Investment TIPS for 2009

I get interested when two of the most successful investors of our time single out the same investment opportunity. Earlier this month, Bill Gross recommended the purchase of Treasury Inflation-Protected Securities, or TIPS, in a note to clients. As the co-chief investment officer of bond giant PIMCO, Bill Gross oversees the management of more than $800 billion in fixed-income securities. Bill knows bonds.

Wait!
Now, before you move on because I'm talking about bonds, I assure you there is a lesson here for all investors who wish to protect their assets -- even those who consider themselves purely stock investors.

In an interview published last week, David Swensen, who manages Yale's $23 billion endowment, mentioned TIPS as an investment he likes. His take? "They promise reasonable returns, and protection against inflation is really important." (Swensen has achieved a 16% annualized return for Yale over the 10-year period ended in June -- a remarkable achievement.)

What are TIPS?
Treasury Inflation-Protected Securities do exactly what they say on the box. They are U.S. Treasury bonds designed specifically to protect investors against inflation. To do that, both the interest and the principal payments are indexed against the Consumer Price Index. So the yield quoted on a TIPS is a "real" return -- that is, an incremental return that's added to the rate of inflation.

When comparing a TIPS and an ordinary Treasury bond (T-bond) of the same maturity, it's possible to assess which one is the more attractive investment by comparing the difference in their yields and deriving the "breakeven inflation rate" -- the rate for which the total return on the TIPS will be equal to that of the T-bond. If the breakeven inflation rate is lower than the actual inflation rate during the period to the bond's maturity, the TIPS will provide a higher overall return than the ordinary T-Bond.

Will the next 10 years be deflationary?
At the moment, the yield on the 10-year TIPS is 1.84% versus 2.60% for a T-bond, implying a breakeven inflation rate of just .75% annually over the next 10 years. Is that scenario possible? Absolutely. In fact, rolling-10-year average inflation rates were lower than this in every month during the period 1929 to 1941.

Still, I think it's pretty unlikely (it has never occurred in any month since January 1942). While we could witness deflation this year and the next, it's difficult to imagine that prices 10 years from now will be a mere 8% higher than they are today. If that is the case, the new administration will have been unsuccessful in its efforts to reinflate the economy with its "bridge-to-the-moon" fiscal stimulus package.

Of course, part of the discrepancy is due to the tremendous overvaluation in Treasury bonds that I highlighted in "A Slam-Dunk Trade for 2009." The surest way to take advantage of the mispricing would be to go long TIPS and sell short same-maturity Treasury bonds -- although I wouldn't necessarily recommend such a strategy for retail investors.

The equity version of TIPS
If you're entirely committed to stocks, there is a segment of the stock market that could be thought of as the equity version of TIPS: high-quality dividend stocks. A well-run dividend payer should be able to increase its dividend at a rate that matches or exceeds inflation, and as the following table demonstrates, many superb companies currently offer yields that exceed those on Treasury bonds:

Stock

Dividend Yield

Pfizer (NYSE: PFE  )

7.3%

Merck (NYSE: MRK  )

5.5%

Coca-Cola (NYSE: KO  )

3.5%

McDonald's (NYSE: MCD  )

3.4%

Johnson & Johnson (NYSE: JNJ  )

3.3%

Procter & Gamble (NYSE: PG  )

2.8%

Microsoft (Nasdaq: MSFT  )

2.7%

Source: Capital IQ, a division of Standard & Poor's.

Note that five of the seven stocks (Pfizer, Coca-Cola, McDonald's, Johnson & Johnson and Procter & Gamble) are part of the S&P 500 Dividend Aristocrats -- an elite group of dividend stocks, all of which have increased their dividends for at least 25 years consecutively.

(By the way, if you think that the comparison between stocks and Treasury bonds is absurd, you should know that Warren Buffett has been known to analyze stocks by treating them as "disguised bonds.")

All dividend stocks aren't created equal
Of course, there is a fundamental difference between investing in TIPS and stocks -- with the latter, neither your principal nor your dividend is guaranteed. It is therefore essential to focus on the highest-quality names and buy only when you can do so with a margin of safety. That is the sole focus of the team at Motley Fool Income Investor, our dividend stock service. If you'd like to start building an armor-plated portfolio of dividend stocks, sign up for a 30-day free trial now.

Fool contributor Alex Dumortier, CFA, has a beneficial interest in Microsoft but has no position in any of the other companies mentioned in this article. Pfizer and Johnson & Johnson are Motley Fool Income Investor recommendations. Pfizer, Microsoft, and Coca-Cola are Motley Fool Inside Value recommendations. The Fool owns shares of Pfizer and Procter & Gamble and has a disclosure policy.


Read/Post Comments (9) | Recommend This Article (49)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On January 24, 2009, at 4:34 PM, beertrain wrote:

    Alex, You could be spot on, however, ..................your presentation of the TIPS leads me to believe this is as easy as forecasting the weather, only the weather is actually easier given the reader could consult the Farmer's Almanac. Fact is, no one knows what programs the administration will actually fund and the effect of said funds.

    The equities presented all offer good value, are a great way for most investors to build a foundation for their portfolios and end up positive at the end of 2009, given they buy at a good discount.

    These stocks are not the mult-baggers that many dream about on this site.

    In all, a nice article.

  • Report this Comment On January 24, 2009, at 6:17 PM, nerd1951 wrote:

    I prefer dividend paying stocks over TIPS because I believe that they are a better hedge against inflation. As you pointed out they yield on TIPS is tied to the CPI.

    The problem is that the government fiddles with the calculation of the CPI "to reflect changes in the economy." I believe that some of the previous adjustments have been politically motivated so that the CPI doesn't keep up with real inflation as we experience it.

    It's in the governments interest to hold the CPI down since many government outlays are based on it; Social Security and Civil Service salaries for example. I'm afraid as time goes on the CPI will become more detached from reality.

  • Report this Comment On January 24, 2009, at 7:25 PM, vinney11 wrote:

    This sounds very close to my plan for investing a coming windfall. The current dividend yield on many stocks ceates a great opportunity to lock in a high yield on cost, while also indicating an undervalued market. The TIPS will provide some safety.

  • Report this Comment On January 26, 2009, at 8:17 AM, SteveTheInvestor wrote:

    The moment I've been expecting has arrived. Pfizer has cut its dividend in half. Doesn't look so great now.

  • Report this Comment On January 26, 2009, at 8:33 AM, pondee619 wrote:

    If the BO stimulus plan comes close to its stated goal of spending one trillion dollars, inflation would have to rise.

    Dividend yields are written in air. They can be cut and/or suspended on the vote of a Board. Check out Pfizer today.

    TIPS may not be the be all and end all, but then what investment is. They will offer protection against inflation and will continue to pay its promised rate to maturity. A fine counter balance to equities.

  • Report this Comment On January 26, 2009, at 12:16 PM, TMFAleph1 wrote:

    I'm not advocating for or against an investment in Pfizer. I simply note that even after the dividend cut, the yield remains higher than that on the conventional 10-year T-bond.

  • Report this Comment On January 31, 2009, at 10:46 AM, slpca wrote:

    I am a brand-new investor. TIPS sound like something I could cut my teeth on. But how/where do I buy them?

  • Report this Comment On January 31, 2009, at 1:16 PM, and2802 wrote:

    Rather disappointing article - or is it just an ad for Income Investor? I expected some information on how TIPS work, mechanically; are they good for taxable or tax deferred accounts; are TIPS funds a good idea; where are individual TIPS bought, etc.

  • Report this Comment On August 28, 2009, at 3:39 AM, Rynaldos wrote:

    If you are just getting into the game of investment and looking for a beginners guide as well as investment options, please visit:

    www.hubpages.com/hub/howtoinvestfordummies

Add your comment.

DocumentId: 816325, ~/Articles/ArticleHandler.aspx, 4/17/2014 2:56:54 AM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...


Advertisement