Just Say ”NO” to TIPS

With concerns over national debt levels and the Federal Reserve printing money like confetti inflation worries abound (and not without good reason!). Traditionally physical ownership of precious metals, most notably gold, has been the main way to protect assets against inflation risk. However, today TIPS are being pushed as a “safe” (or “safer”?) way to get protection. The popularity of TIPS as mushroomed, fueled by both these concerns and eager financial gurus touting them as the best thing since beer in a can.

TIPS – Treasury Inflation-Protected Securities – for those who have yet not heard of them are U.S. Federal Treasury bonds that contain an inflation adjustment component to the interest calculation. They have a fixed coupon rate plus an inflation adjustment add-on to the principle amount. The purpose is to add (or decrease) the inflation adjustment to the principle amount (face value) rate annually. This results in increased (or decreased) semi-annual interest payments a s interest is computed on the adjusted principle amount, and, at maturity you receive the great of the face value of the bond or the adjusted principle.

Sounds like a sweet deal!

But all that glitters isn’t gold. The U.S. Treasury isn’t offering TIPS (and I-Bonds) out of the sheer grace of their over-paid Federal hearts.

TIPS, gold and inflation all have an intertwined history.

The double-digit inflation of the early 80’s saw investors and individuals flock to gold as a protection. They sold securities – most notably fixed income Treasury bonds – to raise the cash to buy gold. New cash was also put into gold instead of Treasuries. The result was obvious to happen: Gold reached then-record highs and the U.S. Treasury had a liquidity problem.

If the government printed more money that added to inflation. If they didn’t interest rates would have to rise to lure back investors to buy Treasury bonds. In the end a combination of approached worked to lower inflation and bring back Treasury investors. But the government learned a lesson.

Enter TIPS.

TIPS has the affect of essentially monetizing inflation. Rather than holding a real, physical, tangible and historically valuable item like gold as a protection against inflation and the unknown, now you can own paper as your protection. Oh joy! And now the Treasury can attract and keep more investors instead of losing them to gold (which is why in the current economy, while gold is at record highs, it has been a slower climb and not as high on an inflation-adjusted basis as the high of the 80’s).

The promise of one paper to protect you against loss of another paper. Seems rock solid to MasterPo!

But there are a few annoying things still nagging at MasterPo.

First, there’s the whole sovereign debt issue (a la Greece). The U.S. may be bigger but at $13.7 TRILLION in national debt (as of writing this) don’t think it can’t happen here.

Second, there’s the politics. The Obama White House announced there was no inflation in 2009. Phuleeze! And it’s been leaked they plan to say there will be no inflation in 2010 and 2011. How wonderful they can predict that!

But let’s go with Fantasy Land for this example. No inflation in 2009, 2010, or 2011 according to the White House.

So explain to an old MasterPo: If the White House says there’s no inflation how can the Treasury give an inflation adjustment to TIPS?!

Third, gold has real value worldwide. Unless something civilization shaking happens on a global scale there will always be an eager market for gold (and if something like that does happen cashing in your gold will probably be the least of your worries!). Can’t say the same for sovereign paper.

If all works out fine and dandy TIPS as a concept is great.

But TIPS are only paper. And what looks good on paper doesn’t always play out the same in the real world.

Nations come and go but gold survives.