WASHINGTON Feb 27 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
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 Jan. 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.