Dire Performance By Volatile TIPS

 |  Includes: TIP
by: John M. Mason

The yield on the 10-year U.S. Treasury Inflation-Indexed bonds rose again yesterday. Now the security is yielding a very robust, positive 60 basis points return!

The Financial Times reports "U.S. Inflation-linked Bond Funds Fall". As can be imagined, all bond funds are suffering because of the rising yields in the bond markets. But, it just so happens that the worst performers in this area are the funds that have specialized in TIPS.

"Pimco's Real Return Asset Fund has lost investors 16.1 percent of their capital in 2013, ranking it as the worst performer in the bond mutual fund universe.

More than four-fifths of the 5,528 bond mutual funds tracked by Lipper have lost money this year.

The dire performance for the 203 funds investing in inflation-linked securities, down 7 percent on average this year, according to Lipper, highlights the volatile nature of what is still a relatively underdeveloped market."

This market in the United States "is dominated by a handful of big institutional investors and large dealers. Trading volumes are far lower than for the Treasury bond market, leading to heightened volatility in times of market stress."

But, this market has, over the past two years, been heavily impacted by the movement of funds out of riskier sovereign debt in Europe as a consequence of the lengthy financial unrest occurring on the continent. Yields on TIPS securities took a nose-dive in the late summer of 2001 and fell below zero. Jeremy Siegel, the financial economist, and Jeremy Schwartz, wrote about this abnormality at the time in the Wall Street Journal.

They wrote at the time: "One market that now makes no sense to us is the popular Treasury Inflation Protected Securities (OTC:TIPS), where recent yields should be enshrined in Ripley's 'Believe It or Not!' The yield on the benchmark 10-year TIPS turned negative for the first time in history, meaning investors are now lending money to the government with the hope of receiving a sum 10 years from now that is worth less in purchasing power than the dollars they fork over today."

Yet these TIPS remained in negative territory from September 2011 until Friday June 7, 2013.

Whereas Siegel and Swartz guessed that the yield on these securities turned negative because of expectations concerning the future growth rate of the U.S. economy. They wrote, "This astounding situation can only be justified by extraordinary pessimism about the prospects for the U.S. economy."

By the next spring it became more apparent what had happened. In April of 2012, I wrote about how investors escaping the financial dislocations in Europe were using the U.S. Treasury market as a "safe haven" for their funds. This "safe haven" effect was so strong that it even took the yields on TIPS below zero … something extraordinarily unusual.

This spring, money began to flow back into Europe and away from the U.S. This movement began before Mr. Bernanke started making his remarks on the "tapering" of Federal Reserve bond purchases and set the foundation, I believe, for the continued selling of U.S. Treasury securities and the rapid rise in Treasury yields.

Given that the market for TIPS is "thinner" than that for the regular Treasury issues, the movement of yields in the TIPS markets has been greater than the rise in the yields on other Treasury securities. Hence the relative performance of bond mutual funds that specialized in these inflation-indexed securities.

Those funds that were active in TIPS with maturities in excess of 10 years have performed the worst. The Financial Times article reports that "Barclays index for that sector has a total return of minus 15 percent so far this year."

As I have written earlier, I believe that the yield on 10-year TIPS should be at least in the range of 1.00 percent to 1.50 percent, so I expect that these yields will continue to rise over the next three- to six-months. In my mind, the major reason this might not happen is that the Euro-crisis…which is not really over yet … will erupt once again and we will get European money flowing back into "safe-havens" once again.

I believe that it is very important to keep an eye on what happens in this part of the financial markets at this time. I feel very strongly that the Federal Reserve CANNOT control the interest rate on TIPS. As a consequence, this part of the capital markets will reflect true market expectations better than perhaps any other area. So, keep a watch here.

NOTE: the Treasury debt auction did not go all that well yesterday. The sale of $35 billion of two-year notes sold to yield 43 basis points, the highest rate the Treasury has had to pay since May 2011.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.