At a recent NCUA listening session in Alexandria, Va., representatives from the agency were asked whether investment regulations might be broadened to allow credit unions to purchase Treasury Inflation Protected Securities. Interest in these securities among institutional investors is quite high these days as many view the Fed’s easy money policy as a precursor to future inflation. The TIPS market has some peculiarities that are important to keep in mind as credit unions prepare for this potential expanded authority.
TIPS are essentially regular fixed-rate bonds where the principal amount increases over time in conjunction with the Consumer Price Index. Each TIPS issue has a “reference CPI” based on its original issue date. Comparing today’s CPI with the reference CPI produces an “index ratio” that governs the current principal amount and periodic interest payments. For example, an investor buys $1 million of a five-year TIPS issue where the reference CPI at issuance was 200. (For CPI, the average price level from 1982-1984 equals 100.) At maturity, CPI has increased to 230, making the index ratio 1.15 (230/200) and meaning the investor will receive $1.15 million in principal. Similarly, each periodic interest payment is a function of the coupon rate, the original principal amount and the index ratio at the time of the interest calculation, meaning coupon payments will generally increase over time in conjunction with CPI gains.
One great benefit of an active TIPS market is that investors can readily gauge the market’s inflation expectations. By comparing the yield on a TIPS issue to the yield on a regular Treasury bond with the same maturity, one can infer the implied inflation rate over the life of the bond. For example, the current five-year TIPS issue maturing on April 15, 2017, has a yield around negative 1.05%. A Treasury bond with a similar maturity, the April 2017 five-year note yields 0.75%. The difference between these two yields, 1.80%, is the “break even” inflation rate for the five-year TIPS. If inflation runs above 1.80% over the next five years, the realized yield on the TIPS will exceed that of the regular bond. If inflation is less than 1.80% over this period, an investor would have been better off buying the regular bond.
TIPS bonds are generally viewed as carrying less interest rate risk than regular bonds. If the yield on 10-year Treasuries rose by 1%, the yield on 10-year TIPS would generally rise less. An overall increase in interest rates is typically explained by improved economic sentiment, and a vibrant economy leads to heightened inflation expectations. Logically, higher inflation benefits TIPS, so the lower prices caused by the overall increase in rates are partially offset by the higher anticipated inflation. A good rule of thumb is to assume a “yield beta” of 50%–if regular bonds see their yields increase by 1%, the yield on the TIPS would rise by just 0.50%–but this beta changes over time and varies through the economic cycle. One implication of a 50% yield beta is that the effective duration of a TIPS bond is half that of a regular bond, so a 10-year TIPS has roughly the interest rate risk of a five-year bond.
If the NCUA makes TIPS a permissible investment, it is unlikely that credit unions will flock into this sector. Even though they offer some upside potential, TIPS are still Treasury credits, and most credit unions investing in five-year bullets will prefer the yield enhancement available from insured CDs, agency bonds or even taxable municipal bonds. We’re a lot more comfortable as an industry assessing credit risk than forecasting inflation. Many credit unions might find some of the quirky aspects of TIPS, such as negative yields and extra accounting entries for the inflation accretion, to be a hard sell to board members.
A small investment allocation to TIPS could make sense as a diversification strategy, but putting too many eggs in this basket might complicate an institution’s asset-liability management. Unlike large TIPS buyers, such as pension funds, we don’t have inflation-indexed liabilities on the balance sheet, so we don’t have a compelling need for assets that track the inflation rate. In fact, given the strong correlation between inflation and interest rates, CUs should eventually perform better with moderately higher inflation. TIPS can actually add to the downside risk of lower rates. We recently observed the ugly side of TIPS in late 2008 when energy prices plummeted.
Still, TIPS will be an intriguing possibility to some institutions. Before leaping in to this market, a credit union needs to understand what conditions would make the trade successful, have the required accounting processes in place to track the investments and educate stakeholders on the downside risk to these bonds.
Andrew McGeorge is vice president-finance at Service Credit Union, Portsmouth, N.H.
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