Wall Street Journal: Good analysis of pluses, minuses of TIPS

Min Zeng wrote a good analysis last week on the rising asset values of Treasury Inflation-Protected Securities — at the same time inflation risk seems to be lessening. As Zeng points out, economic turmoil often leads to higher base yields on TIPS (and lower asset prices), because economic distress usually means lower inflation in the short term and also raises the specter of deflation.

Normally, when fears about the economy flare up, investors flee Treasury inflation-protected securities because their need to hedge inflation risk lessens. That was reflected in the selloff in TIPS that occurred in 2008, when the collapse of the Lehman Brothers Holdings Inc. fueled a deflation scare.

Yet prices of TIPS have surged in recent days, pushing down the 10-year benchmark TIPS yield below zero for the first time since the Department of the Treasury started selling this type of bond in 1997.

The price swings for TIPS have been rather amazing in the last 10 days, given that this is one of the world’s most ‘boring’ investments. For most investors, TIPS are the super-safe ballast in their portfolio. This chart shows that the TIP ETF (in blue) has been outperforming the AGG (aggregate bond market, red) since Aug. 1, and also shows that TIPS prices soared about 3.6% in about 8 days before coming back down a bit:

This is the opposite of what happened in the 2008 financial crisis, set off by Lehman Brothers’ collapse, as this chart shows:

The TIP ETF was down almost 10% during the fall of 2008, while the overall bond market stayed close to zero. When people ask me about the risks of TIPS mutual funds, I speculate: The downside risk is probably about 10% — bad, but not a portfolio crusher.

TIPS are at very lofty levels right now, with negative real yields climbing way up the maturity chart, to right about 10 years. Next week’s reissue of a 5-year TIPS could draw a real yield of as low as negative 0.9%. That is shocking because this same TIPS was first auctioned in April 2011 with a real yield of negative 0.18%. That is a huge swing in four months.

Zeng points to the underlying risk of inflation, even amid this turmoil.

Michael Pond, head of inflation bonds strategy at Barclays Capital Inc. in New York, the world’s biggest dealer on TIPS, said the U.S. consumer price index, stripping out of food and energy, has been running at an annualized rate of 2.5% over the past six months and 2.9% over the past three. Some analysts and economists predict they could tick up further in coming months. …

I think another factor is the Fed’s recent guarantee of ultra-low interest rates for the next two years. TIPS investors know they will have almost no super-safe, higher-yielding options in the next two years (except for I Bonds, which are limited to $10,000 per Social Security number this year, $5,000 next year.) As we face across-the-board low rates, TIPS at least have the advantage of inflation protection, a plus in these uncertain times.

One highly discussed factor is completely missing from this equation: The downgrade of U.S. debt by Standard & Poors. Treasury markets have soared since the downgrade, with the 5-year Treasury falling from 1.32% on Aug. 1 to 0.96% on Aug. 12.

Can a TIPS investment go wrong in this environment? Definitely. Zeng also adds this, quoting Mihir Worah of PIMCO:

TIPs may suffer a selloff should the debt-crisis deteriorate continues, feeding into fears about recession, he said, adding that deflation worries could re-emerge.

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