What’s ahead for TIPS in 2012?

Treasury Inflation-Protected Securities had a quite a year in 2011, with the base interest rate dropping dramatically, especially in the second half of the year. This chart shows the deep drop in yields to maturity since Jan. 3, 2011:

One-year TIPS decline in yieldsIn turn, this deep decline in yield made everyone holding TIPS and TIPS mutual funds ‘richer,’ because the value of those investments also rose dramatically. Here is a chart for the performance of the TIP ETF since Jan. 3, 2001 to Wednesday :

Year-long rise in TIP ETFThe year’s low was hit on Feb. 10, 2011, at $104.91 and the high was yesterday (Jan. 31) with a closing of 119.36. That’s a capital gain of 13.7% from low to high, in just less than a year.

TIPS for trading? I remember reading a TIPS investment analysis, maybe 18 months ago, where the analyst said: ‘The only reason to buy TIPS is for a capital gain. You trade them.’ I was floored by that statement (since I buy TIPS as hold-to-maturity investments) and I thought the analyst was a fool. But … that analyst was clearly brilliant and I was, as always, clueless.

That was the past. Yes, it is possible that TIPS could return another capital gain of 13.7% in the next 12 months. But that is getting fairly unlikely.

I like reading the semiannual/annual reports of the Fidelity Inflation-Protected Bond Fund, because its manager, William Irving, seems determined to give a fair appraisal of the fund’s investment potential. Here is what he said in the latest report:

Q. Bill, what’s ahead for the TIPS market?

A. I believe inflation will remain quite low, given the current weakness of the U.S. economy. Against the backdrop of low inflation, coupled with the Federal Reserve’s pledge to keep interest rates low … I believe it will be extremely difficult for TIPS to perform as well on an absolute basis over the near term as they have in the last six months because their yields are already so low. Furthermore, TIPS could come under pressure if economic growth accelerates faster than investors expect or if interest rates drift significantly higher …

I think that is a fair assessment. There are two risks for investors who use TIPS to pursue a capital gain: 1) interest rates are at a 30-year low and could eventually reverse, possibly even violently, and 2) a stronger economy will lessen the appeal of TIPS against other investments (for example, stocks) and that would likely also lead to higher interest rates.

I don’t think the risk is extreme – possibly a 10-15% loss in mutual funds as TIPS yields return more toward the norm.  Is that likely in the near term? No. The Federal Reserve has a two-ton lid on interest rates. I think the TIPS yields could hang at these current rates, or continue to gently decline, as they have this year.

But it does indicate – possibly – that the limited upside isn’t worth that downside risk.

And it’s important to remember that January 2011 was great buying opportunity for TIPS. In February 2012, not so much.

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