Treasury Inflation Protected Securities (TIPS) are one of the best performing fixed income sectors so far in the fourth quarter. The strength has led to substantially lower yields with the 10-year TIPS yield declining to 1.1%. Quarter-to-date through November 30, the 10-year TIPS yield has declined by 0.47% outpacing the 0.11% yield decline of the conventional 10-year Treasury note.
TIPS are benefiting from a perfect one-two combination of lower yields and rising inflation worries. Rising inflation worries can be measured via the “break-even rate” which is simply obtained by subtracting the 10-year TIPS yield from the yield of the conventional 10-year Treasury yield. A wider yield gap, or break-even rate, is indicative of TIPS prices rising faster (or declining less in the case of rising interest rates) that conventional Treasury prices. The 10-year break-even inflation rate has increased from 1.77% to 2.14% [Chart 1]. A rising break-even rate has added additional fuel to the rise in TIPS prices. Lower TIPS yields are not only the result of lower overall Treasury yields but also investors willing to “pay up” for inflation protection. Recall that TIPS returns are comprised of both inflation compensation, via growth in the Consumer Price Index (CPI), and interest income or yield. Since TIPS offer inflation compensation the yield on TIPS is called a “real” yield, a true yield over and above what the inflation compensation an investor receives. While the break-even rate has risen in response to rising market (as opposed to consumer) inflation fears, the lower real yield reflects the bond market forcing investors to pay a premium for inflation protection.
The main driver of recent TIPS performance has been market anxiety over the Fed being too slow to remove monetary stimulus. At the conclusion of the November 4 FOMC meeting, the Fed reiterated its message of keeping interest rates low for an “extended period”. On November 16 speaking before the Economics Club of New York, Fed Chairman Bernanke reiterated the “extended period” language and made no reference to raising interest rates or removing monetary stimulus. His comments were echoed by several Fed officials, including voting members of the FOMC, who also took a cautionary tone and reiterated the “extending period” message.
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The decline in the 10-year TIPS yield to 1.1% puts it back near a historic low [Chart 2]. The last time the yield on the 10-year TIPS had declined to such a level, it marked the start of notable under-performance. To be sure, the 2008 sell off was exacerbated by forced selling by leveraged investors that is not likely to be repeated on the same scale. Nonetheless, current levels urge caution given the benign inflation backdrop and prospect of higher interest rates.
Given a benign near-term, and perhaps longer, inflation view we find the surge in Treasury Inflation Protected Securities a bit premature and current pace of performance is simply unsustainable. The 4% total return of the Barclays TIPS Index over October and November translates into a 26.8% annualized return. The drop in yields also leaves TIPS more susceptible to a rise in rates. TIPS are often thought of in terms of their inflation protection but interest rate sensitivity can often be overlooked. TIPS did outperform conventional Treasuries during the Treasury sell off over April and May but still only provided investors a 0.20% total return according to Barclays data. We suspect a shortage of TIPS might be exacerbating the rally and in October Primary Dealers suggested the Treasury Department increase TIPS issuance in 2010. We do not find the recent performance run in TIPS the start of a new trend and believe better total return opportunities still exist in Investment-Grade Corporate Bonds, High-Yield Bonds, and Emerging Market Debt.
- This report was prepared by LPL Financial. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.
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