Tax-Exempt Investments: The Best Opportunity Now

September 26, 2008

Treasury Inflation Protected Securities (TIPS) are a unique asset class ideally suited to investment in tax-exempt accounts (e.g., retirement accounts like IRAs and 401ks).  TIPS pay interest like regular treasury bonds, but they also appreciate in line with inflation.  The mechanisms by which they pay out are somewhat convoluted and undesirable from a tax perspective, which may contribute to the discount they currently carry in the market.  If you can buy TIPS in a tax-exempt account you don’t have to worry about these nuances.

The clearest way of valuing TIPS is in terms of the “break-even rate of inflation,” which is the inflation rate at which an investor would earn the same from TIPS as from regular treasury bonds of the same maturity.  If realized inflation exceeds the break-even rate then investors in TIPS earn more.  If inflation is lower than the break-even rate then investors in regular treasuries earn more.

Considering the break-even rate, TIPS are extremely cheap.  For example, the break-even rate on 5-year TIPS is 1.12% — well below current inflation, historical inflation, and even the Fed’s target inflation rate.  The dollar faces a number of inflation risk factors, and the current market bailout by the U.S. Treasury only adds to these risks.

Since TIPS are an undervalued, tax-inefficient asset that offer inflation protection they make an ideal investment for tax-exempt retirement portfolios.  Investors who want heightened exposure to these characteristics can buy leveraged CEFs that invest in TIPS: E.g., WIW and WIA.