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.

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