Asset Management

TIPS: Rising rates and low inflation are an uncommon but painful combination

John Cerra, TIAA-CREF Managing Director and Fixed Income Portfolio Manager

September 18, 2013

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Treasury Inflation Protected Securities (TIPS) are U.S. government bonds that are indexed to inflation and designed to protect investors from rising prices. TIPS outperformed nominal Treasuries over the last several years as investors anticipated rising inflation in response to the policies designed to stimulate economic growth after the great recession of 2007-2009. This year, however, when bond yields spiked in May and June, TIPS underperformed the broader market.

This underperformance is causing many to take a closer look at what’s driving returns in the asset class as inflation remains low. Investors may assume that TIPS should perform well in a rising rate environment, because inflation and rates often rise in tandem during periods of economic improvement. More often than not, sharp increases in nominal rates are accompanied with increases in inflation expectations. The recent increase in rates, however, happened during a period of low reported increases in inflation, which was a double whammy for investors.

Article Highlights

  • TIPS (Treasury Inflation-Protected Securities) have outperformed nominal Treasuries in recent years, primarily because investors feared historically low interest rates and massive economic stimulus programs in the U.S. and other developed markets would create rising inflation.
  • After a long period of outperformance, (TIPS) underperformed nominal Treasuries in the first half of 2013 as fixed-income investors reacted to fast-rising rates and low inflation.
  • TIPS may continue to underperform in coming months if real (inflation adjusted) U.S. Treasury yields continue to rise.
  • Over the long term, however, TIPS should remain an important component of well-diversified fixed-income portfolios.

While they are “inflation-protected,” TIPS are also influenced by factors unrelated to rising consumer prices, including fluctuating interest rates, which are often driven by the daily changing views of investors. An improving U.S. economy has contributed to bond volatility — which could mean more tough times are ahead for TIPS investors as investors in safe havens such as government debt seek higher yields from riskier assets.

Rising rates trigger fear across the bond landscape

Volatility and uncertainty gripped bond markets during the second quarter, as investors reacted to the potential winding down of policies that have kept interest rates low. Federal Reserve Chairman Ben Bernanke said the U.S. central bank would consider “tapering” or scaling back purchases of bonds on the open market, perhaps as soon as this year, should the economy continue to improve. His comments sparked a broad sell-off of bonds, causing interest rates to rise sharply in May and June. Markets have remained unsettled in recent weeks and investors are on edge about the potential early or abrupt end to an historic era of low interest rates.

Real yields turned positive in JuneVirtually all fixed-income sectors sold off broadly in May and June, but TIPS were particularly hard hit. They have declined 6.72% for the year through July compared to a 2.31% decline of the Barclays U.S. Aggregate Bond Index, a broad-based benchmark of investment-grade, U.S. dollar-denominated bonds. This happened while actual inflation has remained low and steady.

Real yields (which are adjusted for inflation) made a dramatic move as they moved into positive territory after spending nearly two years below 0% (see chart). This move highlights one of the risks of investing in TIPS versus other fixed income sectors. Real interest rates are largely driven by expectations of economic growth and the Fed’s monetary policy. With an increasing likelihood of the Fed tapering its asset purchases and with a gradually improving U.S. economy, real rates have risen this year.

TIPS are likely to underperform when real rates rise and inflation remains low, which is what we’ve seen through the first half of 2013.

TIPS are also more sensitive than nominal Treasuries to fluctuating rates, as TIPS portfolios are often characterized by long duration. The longer duration of TIPS strategies helped the asset class outperform when real rates declined, but that same attribute has caused underperformance versus nominal bonds in this year’s rising real rate environment.

An uncommon event: low inflation and higher rates

Core inflation remains below the Fed's target rangeDespite ultra-low U.S. interest rates, dramatically elevated U.S. government deficits and a quadrupling of the Fed balance sheet from $869 billion to $3.6 trillion over the past six years1, the rising inflation normally associated with robust economic growth continues to remain elusive. Inflation, particularly core inflation (which is the U.S. Consumer Price-U Index less food and energy) has remained stubbornly low since 2000 (see chart). The Fed has targeted a core inflation rate of 2 to 2.5%, but in 2013 both core and headline (U.S. Consumer Price-U Index) inflation have remained below target, causing many to fear the prospect of falling prices rather than rising ones. Core inflation excludes food and energy prices as they are volatile and can skew broader, underlying trends in price movement. Headline inflation includes food and energy, showing how these prices collectively change each month.

The absence of rising inflation is not a recent phenomenon. Year-over-year U.S. core inflation has failed to break 4% in any single month since 1992. The lack of rising inflation is rare when combined with fast-rising rates, however, and has been especially harmful to TIPS investors this year.

Short-term outlook for TIPS: Potential for rising rates and muted inflation

Commodities prices fell as EM growth slowedThe U.S. Federal Reserve has repeatedly made clear that it will taper its monthly purchase of some $85 billion in mortgage-backed securities and Treasuries once economic growth has returned to firmer footing. And economic growth for the remainder of 2013 and 2014 could grow at a faster rate than we have experienced since the recession ended in March 2009, with the U.S. economy growing at a faster-than-expected rate of 1.7% in the second quarter, steady employment growth and rising home prices. Should stronger U.S. economic growth take hold and interest rates continue to rise, investors may shift more assets out of safe-haven investments such as U.S. Treasuries and into higher-risk assets such as stocks and high-yield securities, potentially putting upward pressure on rates. The outlook for inflation, however, remains grounded, especially as concern mounts over slower growth in emerging markets. Commodities, an important component of inflation and inflationary expectations, are under pressure as China’s growth has slowed. China, one of the world’s largest commodities importers, appears to be entering a new, slower phase of economic growth as are many other large emerging markets, such as Brazil, South Africa and Russia, which depend heavily on commodities exports. As a result of slower growth, materials prices, which drive an estimated 40% of emerging market economies, have plunged this year.

Looking further out: Caution warranted but no need to panic

The conditions of rising rates and low inflation are reasons for investors to remain cautious when assessing the value of TIPS. We don’t expect this scenario to become permanent, and believe the market will readjust in the coming months as rates further stabilize and economic growth patterns in developed and emerging markets become clearer. Caution remains in order, however, as the recent adjustment in interest rates may continue and market demand for inflation protection remains weak.

Notwithstanding this recent volatility, TIPS remain an important component of any well-diversified bond portfolio, as these investments can protect the long-term value of investor assets against the corrosive effects of inflation.

For more information on TIAA-CREF’s views on fixed income investment in a changing marketplace read:

Inflation-Protected Bonds: Understanding the Risks and Rewards
The recent volatility of high-yield bonds: Spreads widen though fundamentals remain strong
How will the Detroit bankruptcy affect the municipal bond market?
Rising interest rates and your bond portfolio
Finding income and managing risk in a near-zero interest-rate environment
The enduring case for high yield bonds (PDF)

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