Swaping From TIPS To, Well ...... Swaps

There is an interesting article from Bloomberg that discusses how TIPS (Treasury Inflation Protected Securities) are not living up to their goal of protecting against inflation. The principal for TIPS increase with increases in the CPI, yet many bond holders do not feel that the CPI is properly tracking inflation, in particular the large price increases in gasoline and soft commodities, such as corn. Even as prices have increased over the last 18 months, yields on TIPS relative to Treasuries have essentially stayed the same.

As an alternative, some investors are using swaptions, which when purchased give the buyer the right to purchase a swap. Swaptions are essentially options on interest-rate swaps. Inflation swaps allow one party to pay a fixed rate in exchange for the inflation rate. Lately, swaptions have been better at gaining value when the expectations of future inflation increase, even if the CPI is not keeping up. As an example, in April and May one-year inflation swaptions returned about 0.3%, compared with a 2% loss by TIPS of all maturities. Nonetheless, even while reacting to inflation better, some investors still prefer TIPS since they are backed by the government, unlike derivatives that depend on the credit quality of the issuing firm.