No. of Recommendations: 2
This is the daily listing of interest rates.

Right now, I am pondering whether to buy TIPS next year (in my IRA, so the interest won't be taxed. WA state doesn't have an income tax). The alternatives are to buy I-Bonds, which yield 1% over inflation, or CDs.

In my neighborhood, I can get a 5.39%, FDIC-insured 5-year bank CD. This is the competition for both the I-Bond and the TIPS. The interest rate of the CD is fixed, so it will fall behind, should inflation rise more than expected.

According to the Bloomberg web site, Treasuries and TIPS compare as follows, as of today.

Interest rate 5-year 10-year
Treasuries 4.31% 4.36%
TIPS 2.02% 2.02%
Implied Inflation Rate 2.29% 2.34%

Bond traders consider the Treasuries and TIPS to be equally safe, so the difference in the yield is the implied inflation rate (because TIPS will be adjusted, whereas Treasuries will not).

If the actual inflation rate turns out to be higher than the implied inflation rate, over the maturity of the bond, then TIPS would be the better investment.

The flatness of the yield curve is striking. It could indicate an upcoming recession, or higher demand for long-dated debt instruments, from our trading partners, and from pension funds.

Here are the rates of Treasuries and TIPS, at recent auctions:

I don't like the idea of tying up my money for 10 years. Unlike Savings Bonds, TIPS do not guarantee return of principal, should one sell them, before maturity (the value will decline, if interest rates rise). However, the previous interest rate on the 5-year TIPS, at auction, was only 0.875%, which is less than the 1% that is offered by I-Bonds. The interest rate of the regular 5-year Treasuries went up, between the October and December 2005 auctions, but only by 0.125%. If the TIPS only goes up to 1%, at the April auction, the I-Bond, with a fixed rate of 1%, has the advantage (because of its tax and principal-protection features).

Finally, a thought on market pricing of risk. Mish posted the link to this valuable article, called "The Many Faces of Liquidity."

It's clear that the market isn't adequately pricing risk. Alan Greenspan warned about that, last year. If there is a sea change in the market, such that liquidity is destroyed (due to bankruptcies of leveraged speculators), despite the efforts of the Fed to pump liquidity into the system, then the risk premium of bonds will rise to a more normal level. In that case, TIPS from a low-risk-premium environment (the present) would lose their value.

I'd appreciate some input on the macroeconomic trends, and how they would affect this decision.

(posted on both Mishedlo and Fixed Income Boards)
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