Update: How are TIPS holding up through this debt crisis?

Update 18 months later: The TIPS earthquake: When did it happen, and why?

Two years ago, Richard Ferri laid out the worst-case scenario for Treasury Inflation-Protected Securities in an article titled, ‘The Dark Side Of TIPS.’ The Forbes.com article is getting more attention right now as the U.S. grinds toward a potential default on its debt obligations. If that happened,  it could mean a ‘perfect storm’ for TIPS … higher interest rates combined with stable or even declining inflation.

Ferri, founder and director of research at Portfolio Solutions, wrote this in April 2009, well before the talk of default, but he makes many points that apply to this looming issue:

I would not argue with those who say that most long-term investors should have at least some of their retirement money in inflation-indexed bonds. However, there is another side to this story that is rarely discussed. There is a dark side to inflation indexed bonds. …

Overrated risk of inflation?

Let me first say the financial markets have a way of doing things that we least expect. When everyone expects something to happen, it usually doesn’t. Today, a majority of people expect inflation to be a problem in the future because the Fed has increased the money supply significantly …

Currently, monetary policy has placed interest rates near zero percent. The Fed cannot be any more accommodative unless they pay banks to borrow money. The only place interest rates can go is up–and higher interest rates will likely squeeze any inflation out of the system rather quickly as loan demand will drop as soon as rates increase. Consequently, inflation is probably not the big threat that investors think.

Loss of confidence in U.S. debt?

The risk is a loss of confidence by our trading partners who hold trillions of dollars in U.S. Treasury bonds. … Selling may beget selling as one country tries to dump ahead of others. The only way to make U.S. debt attractive again is for real interest rates to go up substantially to match the level of perceived risk in U.S. obligation. That is the big risk for TIPS investors.

That last quote sums up the current risk: If the U.S. defaults on its debt in August, or the rating agencies downgrade U.S. debt before then, would the immediate effect be higher interest rates on U.S. debt? (And, ironically, even higher U.S. debt?)

What this means for TIPS. If you are holding TIPS to maturity, and you have laddered them over many maturity dates and base interest rates, you wouldn’t see much of an effect with a short-term default. Since TIPS just paid semiannual interest July 15, you aren’t likely to miss an interest payment.

Your current, more recent holdings might pay a lower interest rate than new issues, if the higher interest rates continued. But that is the whole idea of laddering. Buy the new issues, get a higher rate.

TIPS mutual funds, though, could take an immediate hit if the base interest rate on TIPS rises. The duration of the TIP ETF is 4.01, so a 2-percentage-point increase in the base rate — which is not out of the question — could cost you 8% or so of your principal. But even that is hardly a ‘perfect storm.’

This scenario would set up a buying opportunity in TIPS mutual funds, in my opinion. (I don’t own any TIPS mutual funds at the moment, so this would be something to watch.)

Will the U.S. default? I hope not. That would be a true disaster, in my opinion. On the other hand, the bond market does not seem worried. Here is a seven-month chart of the TIP ETF:

Does this look like a bond market that is worried about a U.S. default, two weeks from now?

Ferri posted a note today in the Bogleheads forum referencing his April 2009 article and gave this updated opinion:

I don’t believe there is a high probability of the dark side scenario. More likely, Treasury will print as much money as we need to pay our debts, thereby creating an inflationary scenario. This scenario would make TIPS attractive.