Is There a TIPS Disaster Developing? Depends on How, And How Long, You Own Them

by: Michael Ashton

Further to real yields after my comment here. I had several people send me a link to the story “Treasury TIPS: A Looming Disaster for Small Investors.” Several others had previously sent me the Financial Times piece on which the article is based. So is there a disaster developing?

Well, the Wallace article is both right and wrong, as was Siegel’s. The answer depends on how you own TIPS, and for what time period.

As with any bond that matures rather than defaulting, if you hold TIPS to maturity you know exactly what you are going to get: all of your money back, with interest, and with both principal and interest adjusted for inflation (this is actually even better than with a nominal bond, in which you get all your interest and all your principal back, but you don’t know what those dollars will be worth).

Like any bond, if you sell the bond before maturity you do not know what you will end up getting. And, since TIPS funds generally do not have a maturity, this is also true of TIPS funds.

So it’s only a disaster if you buy TIPS now and sell them when real interest rates have risen. And even then, if inflation and inflation expectations have increased you likely will have done better in TIPS than in non-inflation-linked bonds. So the disaster is relative. If you think inflation is going appreciably higher, the first thing you should do is to avoid normal bonds, where interest rates will rise (and mark-to-market principal fall) without any inflation compensation. In that case, you’re long real rates and short inflation; with TIPS you’re only long real rates.

Having said that, real interest rates on TIPS are fairly low (and quite low at the short end) and I sold mine out some time ago. But it is prudent to have some kind of inflation protection, and although OSM isn’t as attractive as when I first wrote about it in May of last year it still is priced to yield around CPI+6% (closing today at $20.35). I also still own USCI, which I wrote about on October 21st.

I would also like to point out that long-term TIPS are yielding over 2%. Will they cause a disaster if the yield rises? Certainly, because they have a long duration. But by the same token, long-term real yields (unlike long-term nominal yields) are somewhat bounded by the relationship of long-term real yields to long-term economic growth. At the peak of the last expansion, 30y TIPS yielded around 2.5%. At the depths of 2010, they yielded around 1.5%. They’re now around 2.15%. Could they go to 4% if nominal rates soared? Assuredly, although remember that if nominal rates are rising because of inflation expectations that will not affect TIPS. But can they go to 6%? Not without some earth-shattering developments. So, even though they have a very long duration, they also have more anchoring. Put another way, long-term real yields have much less volatility, relative to short-term real yields, than long-term nominal yields have relative to short-term nominal yields.

So, while I am delighted that people are finally pointing out that TIPS are not immune to bad mark-to-markets in inflation episodes, as long as you’re holding to maturity or buying them with long-term real rates somewhat above 2%, it’s probably not going to be a disaster. And in the event where you do have significant losses, they will probably be sharply less than your losses in nominal securities in that circumstance (especially your real losses in nominal securities!).

And I will make one final point. If real yields on TIPS are low, that means real yields are low everywhere. Real yields are a component of Treasury yields, but embedded in the nominal yield. Real yields are a component of equity pricing, but embedded in the P/E multiple. And so on. You can’t avoid exposure to real yields by not holding TIPS! If real yields go from 2% long-term to 4% long-term all of these assets will suffer. A rise in real rates represents a rise in the cost of money, and that affects all assets.

Yes, it’s much more fun to be an investor in an era of declining real yields and declining inflation expectations. I hope you had fun over the last thirty years. But we are no longer in that world.