The Treasury Investment That's WAY Better Than Treasury Inflation Protected Securities (TIPS)

I've made no secret of my aversion to Treasury bonds. Yields right now are irrationally low, and thus do not accurately reflect U.S. credit risk.

And since inflation is already running higher than bond yields - and is likely to rise even further - Treasuries offer an inadequate return at best, and at worst, a capital loss if sold before maturity.

Even Treasury Inflation Protected Securities (TIPS) aren't as safe as you might think.

Fortunately, the U.S. Treasury is finally thinking about issuing something useful: Floating rate notes (FRNs).

If the Treasury does end up issuing FRNs, and the pricing is reasonable (and the U.S. Treasury still has a credit rating better than junk bonds), then you should seriously consider buying some.

Don't Trust TIPs

Floating rate debt issues are not that common here, but there have been many in Europe. They were even more common in my early banking days in the 1970s - when interest rates were generally rising.

FRNs have one great advantage over fixed-coupon bonds: If interest rates go up, fixed-coupon bonds go down, sometimes by a lot if the bonds have a long time to maturity.

For example, if 30-year interest rates rise from 4% to 5%, the trading price of a 30-year bond ($100 face value) will drop to $84.48. If you were to sell at that point, you'd lose 15% of your principal - the equivalent of nearly four full years worth of interest.

However, a floating rate note on a good credit rating should always trade near par. If short-term interest rates go up from 1% to 5%, the note will pay 5% in the next interest period, so it will still trade close to par. That means you have principal protection as well as interest rate protection.

Theoretically, TIPS should offer similar protection. And they do if interest rates always stay at the same margin above inflation. But in periods like the present, interest rates trade below inflation, so the price of TIPS gets bid up above par.

Today, 10-year TIPS yield only 0.19% and 30-year TIPS yield only 1.00%. Since real bond yields in normal markets should be in the 2% to 3% range, there is potential for the loss of principal here. Indeed, in real terms there is a certainty of loss of principal - the "on-the-run" 30-year TIPS trade at a price above $128, so over the next 30 years you are bound to turn $128 into $100 in real terms - not a good deal.

Sidestepping Uncle Sam

Additionally, there is another problem with TIPS: The government sets the price index to which TIPS are linked. And if you think the government is too honest to fudge the price statistics to make its debt cheaper, I have some sad, disillusioning news for you.

The U.S. government didn't even start issuing TIPS until 1997. That was after it fiddled with the consumer price index (CPI) to take account of "hedonic changes" - improvements in quality, which it defined by things like the "Moore's Law" increases in computer chip speed. By this measure, the price of computers today is 1/1000 its level in 1997 (The government adjusts the weightings each year to make sure "declines" in computer prices are fully captured).

Of course, if you only use computers for more basic functions like word processing and calculations, they're no more useful now than they were in 1997. Admittedly, Internet access is more efficient, but not much more efficient than it was in, say, 2004.

So the CPI understates inflation, by about 0.8% to 1%, and TIPS thus have about a 0.8% to 1% lower "real" yield than they advertise.

Floating rate notes will not have this problem.

FRNs are likely to be based on the six-month Treasury bill rate, with their interest rate reset every six months, plus or minus a margin. In theory, since six-month T-bills are issued all the time and are completely liquid, while floating rate notes might trade at a discount, that margin ought to be positive.

But in practice, the initial demand for FRNs may be so great that the government can issue them with a zero or negative margin. In that case, investors should be cautious - FRNs with a negative margin are likely to trade at a discount once Federal Reserve Chairman Ben Bernanke is put out to pasture and market conditions are normalized.

However, if the margin is at least a little positive, Treasury floating rate notes are a good deal. Today, they would yield only around 0.06% (plus any margin), but your income would rise alongside interest rates.

More importantly, if inflation were to reach something like 10%, a new Paul Volcker would have to be brought in to get prices under control and short-term interest rates would soar.

Don't forget, six-month Treasury bill yields were above 15% for much of 1981. A return to those levels would certainly make floating rate notes a good investment.

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