Stern Advice: How anti-inflation bonds could smack investors

WASHINGTON Wed Feb 27, 2013 2:09pm EST

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WASHINGTON (Reuters) - Many mom and pop investors buy Treasury inflation-protected securities (TIPS) in the belief that they are as safe as safe can be: The full faith and credit of the U.S. government stands behind them, and their returns adjust to keep up with inflation.

But here's a fact that some may find surprising. If interest rates move up faster than consumer prices do, their TIPS investments can turn around and bite them. A low-yielding inflation-protected bond could actually lose value faster than a comparable non-inflation protected bond in that scenario, according to experts like Gemma Wright-Casparius, a TIPS fund manager for Vanguard and Jason Ware, market strategist and chief analyst for Albion Financial Group in Salt Lake City.

"Anyone who believes TIPS are a safe investment is certainly not doing their homework," he said. "When rates do rise, which eventually they will, there is going to be some pain in TIPS."

Because the stated yield of TIPS is lower than that of regular Treasuries (an inflation adjustment is supposed to make up the difference), they would react more extremely to an increase in rates, said Wright-Casparius. In that rising-rate, low inflation scenario, there wouldn't be the inflation cushion to protect TIPS income streams. "I actually think we are going to see a couple of years of very poor returns in TIPS," she said.

Furthermore, there is reason to believe that scenario could play out exactly that way. Interest rates have been low for a few different reasons: Inflation is low. The Federal Reserve has been buying bonds on purpose to keep rates low as part of its economy-goosing quantitative easing policy. Investors have been bidding up Treasuries (thus dampening yields) as a flight to safety whenever they worry that the economy is weak or unstable.

But some day the Fed will exit its bond-buying program. And investors, already less afraid than they have been, started demanding more return on their Treasuries earlier this year.

Near the end of January, yields on 10-year Treasuries climbed from 1.84 percent to 2 percent, before sliding back to 1.88 percent where they are now. And a 2 percentage point increase in interest rates could shave 14.9 percent off the value of a 10-year bond, according to the American Association of Individual Investors.

Inflation may move up more slowly than interest rates, says Ware. He points out that the economy still has a lot of strengthening to do before it reaches full employment or full capacity use, both measures that typically signal future price increases. The consumer price index has been unchanged for two months in a row. The CPI is up 1.6 percent for the 12 months ending January 31, 2013.

Ten-year TIPS, meanwhile, have been bid up so much their real yield is a negative 0.63 percent, according to Treasury Department auction data from the end of January. TIPS investors are basically betting that inflation will be above 2.5 percent over 10 years.

Of course, that could well happen. Economists are divided about how the Fed's endgame will play out, and some, like Edward E. Leamer at the University of California, Los Angeles, believe that inflation will actually outstrip interest rates before too long. "We are likely to be in a low interest rate environment indefinitely," he said. "I think consumer prices will be rising more quickly than interest rates." A fast pickup in oil prices could push the CPI up in a hurry.

Even in that scenario, Leamer worries about investors putting too much money into bonds, including TIPS. Even with the inflation protection, they'd suffer as rates rose.

His answer? Borrow money when rates are low and use it to buy hard assets that would appreciate in an inflationary environment. "Leverage is a good thing now." Ware suggests keeping bond maturities short (including TIPS), and looking to stock dividends for income instead of betting too much on bonds.

(Linda Stern is a Reuters columnist. The opinions expressed are her own. The Stern Advice column appears weekly, and at additional times as warranted. Linda Stern can be reached at linda.stern@thomsonreuters.com; She tweets at www.twitter.com/lindastern .; Read more of her work at blogs.reuters.com/linda-stern; Editing by Kenneth Barry)

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