TIPS Underperform Treasurys In The 2013 Fourth Quarter

by: Stephen Percoco, CFA

For only the third quarter in the past five years, TIPS returns posted a negative return. The average loss in the 2013 fourth quarter was 1.88%, according to our calculations. By comparison, comparable maturity straight Treasurys lost 1.18%. This was the third quarterly loss this year for TIPS and also the third time that TIPS underperformed straight Treasurys. For the full year, TIPS posted a loss of 7.74%, nearly twice the 3.94% loss for straight Treasurys.

From 2009 (when we began tracking TIPS) and 2013, the only other recorded quarterly loss for TIPS was in the 2010 fourth quarter. Then, both TIPS and Treasurys gave back some of the "flight-to-safety" gains that they had booked during the summer sell-off that year. Over the four years prior to 2013, TIPS had consistently outperformed straight Treasurys, due to high investor demand for inflation protection. Since inflation expectations remain dormant, it is not surprising that TIPS would give back proportionately more of their gains as interest rates begin to normalize.

In the 2013 fourth quarter, longer maturity TIPS suffered the greatest losses, with a decline of 4.84%. By comparison, intermediate TIPS lost 1.47% and short-term TIPS eked out of small gain of 0.13%. Long-term straight Treasurys also lost more than intermediate and short-term Treasurys, but less than TIPS.

TIPS ended the year with an average yield of 0.04%, compared with -0.10% at the end of the 2013 third quarter and -0.92 at the end of 2012. This was the first time since the 2011 second quarter that TIPS ended a quarter with a positive average yield.

Yields on comparable maturity Treasurys ended 2013 at 1.86%, compared with 1.65% at the end of the 2013 third quarter and 1.13% at the end of 2012. This was the highest average yield level for Treasurys since the 2011 second quarter.

TIPS underperformed straight Treasurys in three of the four quarters of 2013. This follows a five-year period where they had generally outperformed straight Treasurys, as investors rushed for protection against inflation. Returns on straight Treasurys have sometimes been more volatile than TIPS, especially during periods of economic and financial market turmoil, when they have been viewed as a safe haven (and inflation expectations have declined).

Chart 1
Quarterly Returns on TIPS vs. comparable maturity Treasurys
From the 2009 First Quarter to the 2013 Fourth Quarter

Source: Prices for TIPS and Treasurys taken from the Wall St. Journal and Barron's. Returns calculated by Lark Research.

For all of 2013, TIPS underperformed comparable maturity Treasurys. On average, according to our calculations, TIPS posted a loss of 7.74%. Treasurys, on the other hand, lost 3.97%. With average yields on TIPS increasing faster than Treasurys, the average spread declined from 205 basis points to 194 basis points. The average yield (for the full year) increased 47 basis points to -0.37% for TIPS, while the average yield on comparable maturity Treasurys increased by 36 basis points to 1.57%.

Chart 2 shows the trend in average TIPS and comparable maturity Treasury yields as well as the average spread between the two. TIPS yields declined steadily from 2009 until the first quarter of 2013, but they rebounded sharply when Treasury yields began to rise in May 2013. This marked the beginning of the return to normal interest rate levels.

At this point, yields on TIPS are still near zero and well below their longer-term averages. Straight Treasury yields also remain low by historical standards. Assuming that interest rates begin to normalize, yields on both should continue to rise in 2014 and beyond.

With the recent snap-back in interest rates and the relative underperformance of TIPS. The spread between straight Treasurys and TIPS has returned to 5-year average levels. This suggests that TIPS do not look especially rich or cheap to straight Treasurys.

Going forward, inflation expectations will likely drive the relative performance of TIPS vs. Treasurys. If the economy continues to recover and interest rates rise, TIPS could outperform Treasurys, especially if inflation expectations rise, as is likely. In that case, the spread between TIPS and Treasurys would increase.

Still, there are no clear signs at this time of an imminent pick-up in inflation (or inflation expectations). Indeed, the IMF recently sounded an alarm on global deflation. We would assign a low probability to the prospects for any long period of deflation; but it cannot be ruled out completely.

Chart 2
TIPS yields, Treasury yields and Spreads
From the 2009 First Quarter to the 2013 Fourth Quarter

Source: Data from WSJ and Barron's. Yield and spread calculations by Lark Research.

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. I have no business relationship with any company whose stock is mentioned in this article.