Professional Documents
Culture Documents
L I E N T
The Mystery of
E T T E R
A R T N E R
TIPS*1
Robert D. Arnott
Chairman, First Quadrant, LP
C T O B E R
2003
E S S A G E
A version of Treasury Inflation Protected Securities (TIPS), or inflationindexed bonds, has been with us for a long, long time. Not merely
since 1997, but since the dawn of the capital markets. After
all, TIPS arent really all that different from stocks!
TIPS arent really
all that different
What does a well-diversified equity portfolio do for us? It
from stocks!
provides income which grows typically slightly faster than
inflation, thereby providing a real yield roughly indexed to
inflation. It also rises if the dividend yield (proxying for the real cost
of capital) falls.
What do TIPS do for us? They provide income which rises with
inflation, that thereby provides a real yield tightly indexed to inflation.
It also rises if the governments real cost of capital, the TIPS yield, falls.
The biggest difference is that TIPS have an expiration date and stocks
dont. A secondary difference is that stocks provide imperfect inflation
tracking. In other words, stocks can be seen as inflation tracking
corporate TIPS consols2, with an unreliable growth kicker averaging
about one per cent per year.
*
1
5%
4%
3%
2%
1%
0%
40-Year R eal
Dividend Growth
-1%
-2%
1840
1860
1880
1900
1920
1940
1960
1980
2000
L I E N T
E T T E R
A R T N E R
E S S A G E
TIPS clearly define the real cost of capital to the government. Before
the launch of TIPS, we needed to infer that cost. For an estimate of
the real cost of capital for the government, we uses long-government
bond yields, less a model for long-term prospective inflation, in Arnott/
Bernstein [2002].3
Finance literature suggests that the real cost of capital should reflect
expected real productivity growth, plus some premium for default risk
and/or illiquidity. Since productivity growth closely tracks real percapita GDP growth, this would point to a real cost of capital for the
government (assuming zero default risk, which isnt quite true)
approximately matching real per capita GDP growth, which has
averaged 1.4% since World War II. Equities should have a risk
premium, reflecting both the volatility of equities and the uncertain
rate of real earnings or dividend growth.
Figure 2 shows that this has been an inaccurate picture, with the
government cost of capital sharply exceeding these levels (particularly
3
Arnott, Robert D., and Peter L. Bernstein, What Risk Premium is Normal?
Financial Analysts Journal, March/April 2002.Sons; 1st edition (April 4,
2003), pg 23.
2003
C T O B E R
10%
9%
8%
7%
6%
5%
4%
3%
2%
1%
0%
1960
1965
1970
1975
1980
1985
1990
1995
2000
T IP S Yield
L I E N T
E T T E R
A R T N E R
Correlation
-0.204 ( -1.9)*
-0.217 ( -2.0)
-0.637 ( -9.0)
+0.597 (+7.9)
C T O B E R
2003
E S S A G E
*As compared with +0.078 correlation since the end of World War II.