Stock markets plummets, why do TIPS also lose value?

While traditional Treasuries are considered safe-haven investments in times of stock market turmoil, Treasury Inflation Protected Securities aren’t as predictable. In fact, TIPS can perform poorly when the stock market is falling sharply.

Here is a chart of what happened from May 26 to June 2, 2011, 5 trading days ending in a bit of economic turmoil:

TIPS versus Traditional Treasuries
The reason: If investors fear a recession is looming, they will also expect inflation to be held in check, and will see deflation as a possibility. Deflation will reduce payouts from TIPS, and so investors in TIPS would demand a premium on the base yield. When the yield goes up, the market price of TIPS issues declines.

The recent runup in TIPS prices reflects a fear of inflation, which seems reasonable because of massive government spending, soaring deficits and a weakening dollar.

And then June 2011 … This week’s sharp stock market decline has been caused by a fear of a weakening economy. Is a double-dip recession a threat? And could that bring on the theat of deflation? Even a threat of deflation could send TIPS reeling. Here is dramatic evidence:

Traditional Treasuries are boosted by deflation. If consumer prices decline by 2% in a year, and your 10-year Treasury pays 2%, your ‘real yield’ is 4%.  But with a TIPS, your principal would decline by 2% under that same scenario. Your ‘real return’ with a TIPS would be the base rate, or about 0.75% for a 10-year TIPS purchased today, minus the rate of deflation, or 2% in this example.

The result is a real return of -1.25% for the TIPS, versus 4% for the traditional Treasury.

And that is why TIPS – especially TIPS mutual funds and ETFs – are not attractive in a time of economic decline. If you hold TIPS to maturity, this isn’t as serious, since the decline will likely be reversed, as it was after March 2009.

About Tipswatch

Author of Tipswatch.com blog, David Enna is a long-time journalist based in Charlotte, N.C. A past winner of two Society of American Business Editors and Writers awards, he has written on real estate and home finance, and was a founding editor of The Charlotte Observer's website.
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