TIPS are Treasury bonds whose principal is adjusted for consumer price inflation; buy $1000 worth of TIPS and their face value will appreciate in line with the rise in the CPI. TIPS have a coupon which is paid on the inflation-adjusted principal, so the coupon functions as a real yield. The owner of TIPS receives a total return that is equal to the rise in inflation plus the real yield. Like all bonds, TIPS prices vary inversely with their real yield. So yesterday's 0% real yield on 10-yr TIPS means that the price of TIPS has reached an all-time high; in absolute terms, TIPS have never been more expensive. (The colored zones in the chart above--click to enlarge--are my way of appreciating the "value" inherent in TIPS' real yield.)
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Another way of assessing the value of TIPS is to compare them to regular Treasury bonds of similar maturity. The difference between the nominal yield on Treasuries and the real yield on TIPS is the "break-even" or expected rate of inflation over the life of the bonds. As of yesterday, the expected annual inflation that is priced into 10-yr TIPS and 10-yr Treasuries is 2.1%, which is just a shade better than the average that has prevailed since TIPS were first issued in 1997, and a little below the 2.4% average annual rate of consumer price inflation since 1997. So relative to Treasuries, TIPS are about "average:" neither expensive nor cheap, because they are priced to an expectation that inflation in the future will be about the same as it has been in the past.
In sum, if you buy TIPS today, you are paying a very high price (i.e., you are receiving a very low real yield) in exchange for the expectation of receiving an inflation adjustment that is in line with historical experience. The main reason TIPS are so expensive is not that investors are willing to pay an exorbitant price for inflation protection; rather, it is that Treasury yields in general are extremely low because investors are extraordinarily risk-averse (i.e., willing to pay an exorbitant price for protection against default) and have very low expectations for future economic growth.
So what does this mean? How would TIPS perform if inflation turns out to be higher or lower than the market currently expects?
If inflation turns out to be higher than expected—say, 5% per year—then 10-yr TIPS would deliver a 5% annual coupon return (zero real yield plus 5% CPI). That would handily beat the 2.1% annual coupon on 10-yr Treasuries.
But what would happen to yields if inflation proved to be significantly higher than is currently expected? Undoubtedly, Treasury (nominal) yields would rise significantly, and the difference between Treasury and TIPS yields would also rise, because future inflation expectations would very likely rise. About the best that TIPS investors could hope for in this scenario would be for TIPS real yields to remain at or close to zero, while Treasury yields rose, perhaps by as much as 500 bps.
It's more likely, however, that in a rising inflation environment all yields, both real and nominal, would rise, with nominal yields rising by much more than real yields. That's because higher inflation would eventually force the Fed to raise rates in both nominal and real terms, and that would push up real and nominal rates higher across the board. Of course, rising real yields would cause the price of TIPS to decline, so even though TIPS investors would benefit directly from higher inflation, the price of TIPS would fall by some amount, thereby offsetting, on a mark-to-market basis, some or even a substantial portion of the higher coupon received.
If inflation turns out to be lower than expected—say, 1% per year—then 10-yr TIPS would deliver a 1% annual coupon return (zero real yield plus 1% CPI). That would not be as much as the 2.1% annual coupon on 10-yr Treasuries, which would be disappointing to TIPS investors. The lack of inflation would likely result in the price of TIPS declining, and their real yields increasing, even as Treasury yields held fairly steady. So a very low inflation environment would probably result in lower TIPS prices and a disappointingly low coupon yield—a double negative whammy, so to speak, which might result in zero or negative holding period returns.
So in the best of scenarios for TIPS investors, TIPS are likely to deliver less than whatever the future rate of inflation happens to be. In the worst of scenarios, TIPS are likely to deliver very low or negative returns. TIPS are not likely to produce exciting returns no matter what happens, because TIPS yields have been forced to extremely low levels by the dismal prospects for U.S. economic growth. In short, TIPS, like Treasuries, are extremely expensive and thus not very attractive, even if you think that inflation is going to come in much higher than the market expects. TIPS would likely outperform Treasuries in a rising inflation environment, but not by a whole lot.
About the only reason to get excited about buying TIPS today is if you believe that a) the prospects for real economic growth are dismal at best, b) you are extremely worried about the potential for default risk, and c) you are convinced that inflation is going to rise meaningfully but the Fed is not going to raise rates very much, if at all. I note that one popular TIPS fund (NYSEARCA:TIP) is very close to its all-time high, and appears to be running out of upside potential.
Disclosure: At the time of this writing, I hold no TIPS and have only a small exposure to WIW, a TIPS fund that is trading at an 11% discount to net asset value.