Q: Can you explain how TIPS work and, given widely-reported negative yields, should we be worried about their future performance?
A: Initially introduced in 1997, U.S. Treasury Inflation Protected Securities (TIPS) are bonds designed to prevent inflation from eroding their returns. Like other bonds, TIPS are issued with a fixed rate coupon payment and maturity date. Unlike most other bonds, however, the principal value of TIPS changes periodically to keep pace with inflation (as measured by the Consumer Price Index). As a result, for the life of a TIPS bond, investors are guaranteed their investment will keep up with inflation.
Consider a newly-issued $10,000 TIPS bond paying 2%. At the end of the Year 1, if inflation has been 0% an investor will have received $200 in income with no change to the face value (principal) of the bond. Let’s assume inflation runs 4% in Year 2. To protect the investor against this inflation increase, the principal value of the TIPS bond adjusts upwards by $400 ($10,000 x 1.04) to $10,400. The investor still earns the 2% coupon, but on the higher value such that total income has increased to $208 ($10,400 x .02). At maturity, investors receive the higher of the inflation-adjusted principal value or the original face value of the bond.
TIPS have enjoyed particularly strong returns of late. Since the lows of 2009, the Barclays U.S. TIPS Index has grown by 9.5% per year. While we’d offer no predictions, it might be unwise to bank on such performance going forward. Why? Investor demand and a decline in general interest rates has driven TIPS yields to such low levels that it’s difficult to argue they can fall much further.
Such low yields—negative in some cases—have been seized upon by the media, which claim investors are “guaranteed to lose money” by investing in TIPS today. We’d remind investors these are the same headlines we saw in 2010 when, for the first time ever, the U.S. Treasury issued TIPS with a negative yield. To date at least, the death of inflation-protected bonds has been widely exaggerated—TIPS returned 13.5% in 2011 and nearly 7% in 2012.
We’d also point out that negative yields on a TIPS bond simply imply the expected inflation rate is higher than the current Treasury bond yield. On February 6, for example, 10-Year Treasury bonds yielded 2%. The comparable 10-Year TIPS bond offered a “real” yield of -0.58%. The difference between these two yields is the market’s expectation for inflation over the next ten years: 2.58%.
Why are investors eager to lock in apparent negative real returns on TIPS? For starters, investors seem drawn to the safety and security provided by the U.S. Treasury. Investors may also simply expect future inflation adjustments to turn bonds with negative yields into bonds with a positive return. Put another way, the buyer of the 10-Year TIPS at -0.58% expects inflation to be more than 2.58%, which would cause the TIPS bond to perform better than the conventional Treasury bond.
Editor’s Note: This article was originally penned by our late colleague, Gordie Gorsuch, whose timeless wisdom lives on in Vista’s investment philosophy.