There seems to be a lot of confusion about TIPS (Treasury Inflation Protected Securities) lately, as concern on inflation spreads. I hope this can help clarify some of the confusion. This will be long and wonky, so I'll highlight the conclusions just in case you're in a hurry and trust my analysis, which is not recommended.
TIPS is a very unfortunate misnomer and the way it's structured and yield quoted only adds to the misunderstanding. It is arguably one of the harder ones to understand in bond land.
1. TIPS principal payback offers some deflation protection.
TIPS have an embedded put option on CPI in the form of a floor on principal payback. Let's look at an example.
Example 1: Say you buy $100 worth of newly issued 1-year TIPS (no such a thing; TIPS starts at 5-year) at par with a 2% coupon, and then CPI promptly drops to -10% (some impossible event, like, a major bank goes *poof*) the next day and stays there for the next year, assuming CPI does reflect the purchasing power of the dollar, which is questionable but never mind for now, so that $100 today has the same purchasing power as $90 a year later.
In this scenario you get $1.85 interest and $100 back in a year -- adjusted principal will be $90 by then but that's only used for calculating interest; the principal payback will not be less than the original amount. But $101.85 in a year is worth $113 today, which translates to 13% real return or 3% higher than holding cash -- not shabby for such severely deflationary times -- although the nominal return is only 1.85%.
The differences between nominal return, real return considering inflation, and excess return over holding cash are crucial for real-money investors. Recently in Zimbabwe, you could've gotten a 10,000% nominal return in the stock market and still ended up poorer because inflation had been 100,000% during the same time period (I shall try to resist the temptation of drawing parallels). During deflationary times, holding cash gives you 0 nominal return but good real return, and anything above 0 is an extra bonus.
But in this case, wouldn't the nominal bonds be even better deflation protection if the coupon is higher than the average effective rate for TIPS? No, what matters is the yield, not coupon, because in this case you'd pay premium, making the effective interest rate on your investment lower than the coupon rate. Arbitrageurs will make sure the effective yields are roughly the same (more later on quoted yield for TIPS).
But if arbitrageurs make sure everything is equal, why do we bother picking this over that?
2. TIPS are not as bad as nominals as inflation heats up, and not as good when the deflation shadow grows.
Arbitrage usually works in short time scales. If/when inflation expectation is steady, TIPS and nominals are the same. It's when things change that the two get out of whack. As inflation expectation goes up, TIPS outperforms nominals because the expected interest and principal payback both increases, and vice versa. The choice between TIPS and nominals has nothing to do with the current inflation level or expectation (whether it's -10% or +10%) but everything to do with your outlook on whether it'll go higher or lower in the future.
It's an evolutionary tragic comedy -- efficient, but pathetic nonetheless -- that humans have grown to instinctively rely on linear extrapolation. When inflation heats up, people assume it'll keep going up at the same speed, and vice versa. The difference in performance gets exaggerated with two components, one to adjust to higher inflation now and another to price in still higher inflation expectation in the future. In this sense, I believe it's generally more intuitive to use inflationary/deflationary to describe the second-order change in CPI, as opposed to first-order. In other words, if inflation is falling from high levels but still positive, it's still "deflationary."
But wait, if TIPS and nominals are good deflation protection, why did the yields shoot up during the '08 crisis?
3. The 2008 crisis was a capital black hole, not a simple deflation as shown by the chart below:
The TIPS curve is the 5-year constant maturity yield since it became available in early 2003. The CPI Exp curve is the difference between 5-year CMT (nominal) yield and 5-year TIPS yield. The CPI-U curve is the MoM % change of the unadjusted series, which is used for TIPS Inflation Index Ratio calculation.
In the deflationary phase of a normal business cycle, both the red line and the green line should go down -- bonds are good for bad times. The latter is due to the fact that TIPS yield will go down as deflation protection (nominal yields go down more) or, from another perspective, cost of capital drops as demand drops. But the TIPS yield spiked following the Lehman weekend. This was due to panic unwinding and the resulting demand spike for cash by financials.
On the contrary, from the Euro crisis in May to QE2 in November of 2010, the chart clearly showed a deflationary trend. Some financial analysts, advisors or otherwise experts interpreted the negative TIPS yield in Oct, 2010 as an indication of high inflation expectation. This would've been funny if it weren't so sad -- do these experts even understand the basics of TIPS? If you expect hyper-inflation, it would be stupid to buy TIPS at a negative yield (pay premium in price) because the discounted present value of higher principal payback will be exactly the par principal today; instead, you buy gold (GLD, PHYS), silver (SLV, PSLV), or other hard assets (e.g., DBA, DAG). You rush out to buy TIPS at a premium when you expect deflation AND when the nominal yields have been killed by the Fed, because the $100 principal payback is equivalent to $110 today.
Disclosure: I am long GLD, DBA, SLV. I am also long TIPS bond.