Treasury Inflation-Protected Securities

By David Enna, Tipswatch.com

This article is the sixth in a series looking at how my three favorite bond funds — Vanguard Short-Term Inflation Protected (VTIP), Schwab U.S. TIPS (SCHP) and Vanguard’s Total Bond (BND) — performed after 2013, when the Fed signaled it would back off on bond purchases and eventually raise short-term interest rates.

Why do this? Because we may be heading into a similar scenario in 2022 and beyond, with the Fed tapering bond purchases and eventually (and gradually) raising short-term interest rates. The performance after 2013 could tell us a lot about what’s ahead.

To recap, here are the three bond funds I am tracking; they are three conservative, liquid, mainstream bond funds with very low expense ratios. Here’s a summary of their basic statistics and performance:

2018: Did the Federal Reserve go too far?

Bond funds had a mediocre — but not disastrous — year in 2018, even with the Federal Reserve raising its key short-term interest rate, the federal funds rate, four times in the year. Here was the Fed’s rate-hiking schedule:

• March 21, 2018: Increase of 25 basis points, to a range of 1.50 – 1.75.%
• June 13, 2018: Increase of 25 basis points, to a range of 1.75 – 2.00%
• Sept. 26, 2018: Increase of 25 basis points, to a range of 2.00 – 2.25%
• Dec. 19, 2018: Increase of 25 basis points to a range of 2.25 – 2.50%

The December 19 increase was the last of a string of nine rate increases dating back to December 2015. At the time, a lot of financial experts (joined by a non-financial-expert U.S. president) criticized the final December increase as going too far, too fast. The financial markets went into a tailspin, as noted in this Dec. 20, 2018, report from The Guardian:

“The Dow Jones industrial average dropped 70 points after the announcement to finish the day down 1.49%, while the S&P 500 lost 39.2 points, or 1.54%. US stocks are on course for their biggest December decline since 1931, the depths of the Great Depression.

“The selling spread into Asian trade on Thursday, where the Nikkei in Tokyo was down 2.3% and the Hong Kong market was off 1.1%. In China, the Shanghai Composite was down 0.8%. …

“(President) Trump has waged a public campaign to halt further rate rises, a highly unusual move for a president, calling the increases ‘crazy’ and ‘foolish’ and arguing the Fed’s policy was’“the “biggest threat” to the US economy, larger than the administration’s trade dispute with China.’ “

The S&P 500 fell nearly 15% from December 1 to December 24 and ended the month down nearly 10%. Against that backdrop, the bond market looked relatively serene. Here are the statistics for 2018:

By the end of the year, the yield curve had completely flattened, screaming a warning of a future recession. On Dec. 31, the 4-week Treasury was yielding 2.44%, the 5-year, 2.51%, and the 10-year, 2.69%. Real yields had inverted, with the 5-year TIPS ending the year with a higher real yield than the 10-year, as this chart shows:

On Dec. 20, 2018, a 5-year TIPS reopening auction generated a real yield to maturity of 1.129%, the highest in nearly 10 years. That was one of the greatest auction bargains of the last decade. One year later, a TIPS reopening auction of the same term generated a real yield of just 0.02%.

Amid all this rate-hiking fury, all three of our ETFs lost in net asset value in 2018, despite a gentle rally toward the end of the year. Here is the trend in net asset value, which does not reflect fund distributions:

Vanguard’s short-term TIPS fund, VTIP, ended up being the best performer in both net asset value and total return, generating a positive total return of 0.56% in 2018. Inflation in 2018 ran at 1.9%, enough to keep TIPS competitive. Still, Schwab’s U.S. TIPS ETF was the loser for the year. The total bond market was nearly flat, benefiting from nominal bond yields topping 2% across all maturities at the end of the year.

Conclusion

December 2018 was the peak of the Federal Reserve’s “non-accommodative” policy, after allowing short-term interest rates to top out at about 2.5%. The bond market flattened, but didn’t implode. It was the stock market’s harsh reaction that pushed the Fed into a corner. And just keep this in mind: The S&P 500’s total return declined only about 4.5% in 2018, after rising about 21.7% in 2017. Once again, my long-held theory proved true: The Fed will act to protect the stock market.

Coming tomorrow: A look back to 2019

• 2013: A year of surging real and nominal yields
• 2014: The deck was stacked against TIPS funds
• 2015: The Fed actually did something!
• 2016: Inflation rises; TIPS out-perform the overall bond market
• 2017: ‘The calm before the storm’
• 2019: The Fed cries ‘uncle’; bond investors celebrate
• 2020: Chaotic year of pandemic fears, stunning stimulus
• 2021 and beyond: What’s ahead for U.S. financial markets?

* * *

David Enna is a financial journalist, not a financial adviser. He is not selling or profiting from any investment discussed. The investments he discusses can purchased through the Treasury or other providers without fees, commissions or carrying charges. Please do your own research before investing.

By David Enna, Tipswatch.com

This article is the fifth in a series looking at how my three favorite bond funds — Vanguard Short-Term Inflation Protected (VTIP), Schwab U.S. TIPS (SCHP) and Vanguard’s Total Bond (BND) — performed after 2013, when the Fed signaled it would back off on bond purchases and eventually raise short-term interest rates.

Why do this? Because we may be heading into a similar scenario in 2022 and beyond, with the Fed tapering off bond purchases and eventually (and gradually) raising short-term interest rates. The performance after 2013 could tell us a lot about what’s ahead.

To recap, here are the three bond funds I am tracking; they are three conservative, liquid, mainstream bond funds with very low expense ratios. Here’s a summary of their basic statistics and performance:

2017: ‘The calm before the storm’

Looking back, 2017 was the final year of relative bond market stability in the post-2013 era of “winding down quantitative easing.” This was despite three — yes three! — increases in the Federal Reserve’s key short-term interest rate. They came like this:

• March 17, 2017: Increase of 25 basis points to a range of 0.75 – 1.00%
• June 14, 2017: Increase of 25 basis points to a range of 1.00 – 1.25%
• December 13, 2017: Increase of 25 basis points to a range of 1.25 – 1.50%

The result wasn’t a taper tantrum, like in 2013, but the bond market’s yield curve began to flatten, often considered an omen of economic recession. The theory is: Longer-term yields will rise along with short-term yields (which are set by the Fed) if the market sees solid economic growth in coming years. But the market in 2017 wasn’t seeing that, and its pessimism suppressed longer-term yields and led to a relatively benign year for the bond market.

Here was the year’s trend in 5- and 10-year real yields, which became dramatically tighter at the end of the year:

But really, very little happened in 2017. Yields across the board — nominal and real — stayed in attractive zones, with real yields solidly above zero and inflation breakeven rates running at a reasonable 2.0%. Here are the statistics for 2017:

Note that inflation ended 2017 at an annual rate of 2.1%, giving support to the Fed’s decision to gradually — and consistently — increase interest rates.

This was the beginning of a wonderful — and too brief — era when you could find money market accounts paying 1.5% and 5-year bank CDs paying up to 3%. It was also a year of relative peace in the bond market, even with Fed rate increases looming. This chart shows the trend in net asset value for our three funds, and although there was a lot of low-bore volatility, all three funds ended up for the year, even before distributions:

The flattening yield curve held down the potential of Vanguard’s short-term TIPS fund, VTIP. When you look at total return, the total bond market (represented by BND) performed the best, but SCHP also had a good year.

All of this was setting up a more dramatic bond market in 2018, when the Federal Reserve continued to raise interest rates … four times. While 2018 wasn’t a disastrous year, it broke a two-year trend of relative stability in the bond market.

Coming tomorrow: A look back at 2018

• 2013: A year of surging real and nominal yields
• 2014: The deck was stacked against TIPS funds
• 2015: The Fed actually did something!
• 2016: Inflation rises; TIPS out-perform the overall bond market
• 2018: Did the Federal Reserve go too far?
• 2019: The Fed cries ‘uncle’; bond investors celebrate
• 2020: Chaotic year of pandemic fears, stunning stimulus
• 2021 and beyond: What’s ahead for U.S. financial markets?

* * *

David Enna is a financial journalist, not a financial adviser. He is not selling or profiting from any investment discussed. The investments he discusses can purchased through the Treasury or other providers without fees, commissions or carrying charges. Please do your own research before investing.

By David Enna, Tipswatch.com

This article is the fourth in a series looking at how my three favorite bond funds — Vanguard Short-Term Inflation Protected (VTIP), Schwab U.S. TIPS (SCHP) and Vanguard’s Total Bond (BND) — performed after 2013, when the Fed signaled it would back off on bond purchases and eventually raise short-term interest rates.

Why do this? Because we may be heading into a similar scenario in 2022 and beyond, with the Fed tapering off bond purchases and eventually (and gradually) raising short-term interest rates. The performance after 2013 could tell us a lot about what’s ahead.

To recap, here are the three bond funds I am tracking; they are three conservative, liquid, mainstream bond funds with very low expense ratios. Here’s a summary of their basic statistics and performance:

2016: Real yields fall, nominal yields rise. TIPS are the winner

In general, when nominal yields (like those on traditional Treasurys) rise and fall, real yields (like those on TIPS) follow pretty much along, separated by “the inflation breakeven rate” — the market’s expectation of future inflation. The exception occurs when inflation expectations change dramatically, and in 2016, that happened.

Official U.S. inflation had run at an annual rate of 1.5% in 2013, 0.8% in 2014 and 0.7% in 2015. But in 2016, surging gasoline prices (up 9% year over year) pushed official U.S. inflation up 2.1% for the year. Just like today, though, this surge in inflation partly resulted from weak prices a year earlier. Inflation had declined 0.1% in December 2015, ending that year at 0.7%.

Nevertheless, this surge in inflation seemed to justify the Federal Reserve’s intention to continue gradually increasing its federal funds rate, which rose 25 basis points on Dec. 14 to a range of 0.5 – 0.75%, the second of nine eventual rate increases. Here are the 2016 statistics:

At this point, remember, the Federal Reserve had ended its bond-buying quantitative easing efforts in October 2014. And even though real yields fell in 2016 for all maturities, TIPS still maintained a yield positive to inflation. (This is the sort of thing you see when the Federal Reserve has stopped manipulating the market. Ahh, nostalgia.)

The divergence in yields — falling real yields and rising nominal yields — is directly related to inflation expectations. The market was pricing in higher future inflation, as can be seen clearly in this trend chart for 2016:

Under these conditions, you’d expect TIPS to out-perform nominal Treasurys, and they did. Here is how our three funds performed in 2016, with the chart showing changes in net asset value and not reflecting distributions:

Well into 2016, Schwab’s U.S. TIPS ETF (SCHP) was having a spectacular year, up 7% in net asset value. But all three bond funds took a clipping from October to November as it became clear the Federal Reserve would carry through with its plan for a December rate increase.

Again, net asset value can be a misleading measure of a bond fund’s performance because it does not reflect distributions. But SCHP was 2016’s clear winner, driven higher by 1) falling real yields and 2) higher inflation adjustments to principal. Both VTIP and BND also had respectable total returns of about 2.5%.

Conclusion

For bond investors, 2016 was a good year, even with the Federal Reserve carrying through with its well-signaled December 2016 increase in short-term interest rates. The divergence of yields — with real yields falling and nominal yields rising — gave the TIPS funds an advantage. In the years from 2013 to 2021, this was the year with the strongest divergence. We’ve seen something similar in 2020 and 2021, but not to this degree.

Coming tomorrow: A look back to 2017

• 2013: A year of surging real and nominal yields
• 2014: The deck was stacked against TIPS funds
• 2015: The Fed actually did something!
• 2017: ‘The calm before the storm’
• 2018: Did the Federal Reserve go too far?
• 2019: The Fed cries ‘uncle’; bond investors celebrate
• 2020: Chaotic year of pandemic fears, stunning stimulus
• 2021 and beyond: What’s ahead for U.S. financial markets?

* * *

David Enna is a financial journalist, not a financial adviser. He is not selling or profiting from any investment discussed. The investments he discusses can purchased through the Treasury or other providers without fees, commissions or carrying charges. Please do your own research before investing.

By David Enna, Tipswatch.com

This article is the third in a series looking at how my three favorite bond funds — Vanguard Short-Term Inflation Protected (VTIP), Schwab U.S. TIPS (SCHP) and Vanguard’s Total Bond (BND) — performed after 2013, when the Fed signaled it would back off on bond purchases and eventually raise short-term interest rates.

Why do this? Because we may be heading into a similar scenario in 2022 and beyond, with the Fed tapering off bond purchases and eventually (and gradually) raising short-term interest rates. The performance after 2013 could tell us a lot about what’s ahead.

To recap, here are the three bond funds I am tracking; they are three conservative, liquid, mainstream bond funds with very low expense ratios. Here’s a summary of their basic statistics and performance:

In 2015, something actually happened!

After two years of hinting and signaling, in 2015 the Federal Reserve finally raised short-term interest rates. But that 25-basis-point increase in the federal funds rate came very late in the year, on Dec. 16, 2015. It was the first of nine rate increase that would come over the next three years.

In reaction — and without the ballast of any Fed bond-buying program — real and nominal interest rates increased in 2015 across the board. The move higher was less drastic than we saw in 2013, but TIPS yields surged a bit higher than yields of nominal Treasurys. Here are the 2015 statistics:

Note that inflation for the year 2015 ran at only 0.7% year over year. When TIPS yields increase faster than nominals, and inflation runs lower than expected, the result is that TIPS funds under-perform the overall bond market. The lack of Federal Reserve bond-buying in 2015 is a significant factor, too. Inflation in 2015 was running at 0.7%, but a 10-year nominal Treasury was yielding 2.27% and TIPS real yields were well above zero. Compare that to today, with annual inflation currently running at 5.0% and the 10-year Treasury yielding 1.33% and real yields for all TIPS of all maturities well below zero.

Here is how these funds performed in 2014, with the chart showing changes in net asset value and not reflecting distributions:

In a year of rising interest rates, VTIP was the apparent “safe harbor” because of its low duration, meaning it was less sensitive to rising rates.

But the chart is a bit misleading, because it does not include distributions. When you look at total return, BND (the total bond market) outperformed both VTIP and SCHP because inflation adjustments couldn’t match the higher nominal yields of the total bond market.

The TIPS market in December 2015 was actually very attractive for new purchases. A five-year TIPS reopening auctioned on Dec. 17, 2015 with a real yield of 0.472%, the highest in five years. This TIPS had original auctioned in April 2015 with a yield to maturity of -0.335%. So from April to December, the 5-year real yield surged 80 basis points higher. Great for investors, but bad for holders of TIPS funds.

Conclusion

In reality, 2015 was not a disastrous year for TIPS or the bond market, even with the late-in-year increase in short-term interest rates. The Federal Reserve had done an excellent — and lengthy — job of signaling the increase, and the bond market handled it without any sort of “tantrum.” For most bond investors, it was a flat year, as reflected by the 0.56% total return of the total bond market.

A key (and rather obvious) lesson is that in times when inflation runs at very low levels, nominal bond funds like BND are highly likely to out-perform inflation-linked funds.

• 2013: A year of surging real and nominal yields
• 2014: The deck was stacked against TIPS funds
• 2016: Inflation rises; TIPS out-perform the overall bond market
• 2017: ‘The calm before the storm’
• 2018: Did the Federal Reserve go too far?
• 2019: The Fed cries ‘uncle’; bond investors celebrate
• 2020: Chaotic year of pandemic fears, stunning stimulus
• 2021 and beyond: What’s ahead for U.S. financial markets?

* * *

David Enna is a financial journalist, not a financial adviser. He is not selling or profiting from any investment discussed. The investments he discusses can purchased through the Treasury or other providers without fees, commissions or carrying charges. Please do your own research before investing.

By David Enna, Tipswatch.com

This article is the second in a series looking at how my three favorite bond funds — Vanguard Short-Term Inflation Protected (VTIP), Schwab U.S. TIPS (SCHP) and Vanguard’s Total Bond (BND) — performed after 2013, when the Fed signaled it would back off on bond purchases and eventually raise short-term interest rates.

Why do this? Because we may be heading into a similar scenario in 2022 and beyond, with the Fed tapering off bond purchases and eventually (and gradually) raising short-term interest rates. The performance after 2013 could tell us a lot about what’s ahead.

None of this happened in 2013, but the Federal Reserve issued enough signals that the bond market reacted with a “taper tantrum,” sending both real and nominal yields sharply higher. Read about what happened in 2013 here.

To recap, here are the three bond funds I am tracking; they are three conservative, liquid, mainstream bond funds with very low expense ratios. Here’s a summary of their basic statistics and performance:

2014: The deck was stacked against TIPS funds

Even though real and nominal interest rates declined in 2014 — reversing the overreaction of 2013 — this wasn’t a good year for TIPS and TIPS funds. Why? Because the yield curve began flattening (with shorter-term yields rising and longer-term yields falling) and inflation slumped to 0.8% year-over-year. Here are the 2014 statistics:

Again, note that the Federal Reserve did not raise interest rates in 2014. But it did taper away from its bond purchases, gradually tightening the money supply. This raised recessionary fears, and longer-term interest rates declined. But there was one exception: Real yields rose for shorter-term TIPS, in reaction to short-term deflationary fears. The annual inflation rate came in at 0.8%, so those fears were justified. TIPS perform best when interest rates decline or stay stable, and inflation rises. The opposite was happening in 2014. The overall TIPS market is heavily skewed toward the shorter-term, with about 20 of 44 total issues maturing in the next five years. This yield flattening trend was not good for a short-term TIPS fund like VTIP, or even a broad-based TIPS fund like SCHP.

Here is how these funds performed in 2014, with the chart showing changes in net asset value and not reflecting distributions:

The TIPS market took a deep dive beginning in September 2014, an issue I addressed back then in this article. The trigger was the Sept. 17 release of minutes from a July Federal Reserve meeting. In those minutes, the Fed said:

In light of the cumulative progress toward maximum employment and the improvement in the outlook for labor market conditions since the inception of the current asset purchase program, the Committee decided to make a further measured reduction in the pace of its asset purchases. …

If incoming information broadly supports the Committee’s expectation of ongoing improvement in labor market conditions and inflation moving back toward its longer-run objective, the Committee will end its current program of asset purchases at its next meeting.

The Fed, in essence, said it was preparing to end its asset purchases within a few months. Purchases were eventually halted two months later, in October. But the Fed did not change its policy on near-zero short-term interest rates. The first rate increase didn’t come until Dec. 16, 2015.

Those Fed meeting minutes halted the rally in longer-term TIPS, and sent shorter-term TIPS yields higher. For the year, VTIP was the worst-performing fund of the three, hit by a combination of higher real yields and very low inflation. BND’s total return out-performed SCHP’s, mainly because the inflation gains for TIPS were too weak to match the higher nominal yields of the overall bond market.

BND was the winner in 2014. SCHP took a volatile course toward a fairly good year. VTIP was the loser.

Conclusion

It’s highly likely that after the Fed acts to halt bond purchases and — eventually — raise short-term interest rates, we will see the yield curve flattening, which will benefit longer-term issues. VTIP could do fine in that scenario, as long as U.S. inflation remains rather high. SCHP would do even better, most likely.

• 2013: A year of surging real and nominal yields
• 2015: The Fed actually did something!
• 2016: Inflation rises; TIPS out-perform the overall bond market
• 2017: ‘The calm before the storm’
• 2018: Did the Federal Reserve go too far?
• 2019: The Fed cries ‘uncle’; bond investors celebrate
• 2020: Chaotic year of pandemic fears, stunning stimulus
• 2021 and beyond: What’s ahead for U.S. financial markets?

* * *

David Enna is a financial journalist, not a financial adviser. He is not selling or profiting from any investment discussed. The investments he discusses can purchased through the Treasury or other providers without fees, commissions or carrying charges. Please do your own research before investing.