By Karen Brettell
NEW YORK, April 20 (Reuters) – The U.S. government’s
inflation-linked bonds have become increasingly popular among
investors who fear a jump in consumer prices, but less
sophisticated buyers run the risk of large losses they may not
understand.
Treasury Inflation-Protected Securities, or TIPS, are bonds
whose principal increases when consumer prices rise. Based on
the rise in principal, the interest paid on them also increases.
The debt was among the best-performing assets in the last
year, producing a total return of around 12 percent.
Even though TIPS provide compensation for inflation,
however, the securities are still susceptible to many of the
factors that cause losses in conventional bonds — something
fund managers say many retail investors do not understand.
“I think most investors buy TIPS for the inflation-protected
properties that the bonds have, anticipating that on an increase
in inflation that the underlying asset will be protected,” said
Gemma Wright-Casparius, a portfolio manager at Vanguard.
“Sometimes what investors forget is that they are bonds and
when inflation is rising, typically the price value of the bonds
is going down. It is possible to have a negative return,” she
said.
Ultimately, any rise in bonds’ yields — due to inflation or
other reasons — could cause losses in TIPS. Given that
government bond markets are trading at historically expensive
levels, the scale of any losses could be large.
Assets in TIPS funds have increased to $132 billion as of
the end of February, up from $82 billion at the end of November,
2009, according to data by Thomson Reuters’ Lipper.
Concern over investors’ misunderstanding has also produced a
burgeoning industry in exchange-traded products based on TIPS
indexes that are designed to offer a return more strongly
correlated with inflation moves.
WHAT GOES UP, GOES DOWN
Fears over rising inflation have steadily increased since
the Federal Reserve launched its first bond purchase program in
2008, while more recently, better economic data and volatile
gasoline and energy prices have also stoked fears that price
rises may accelerate at a faster pace.
Inflation, though on the rise, thus far has been contained.
In the last year consumer prices rose at a moderate rate of
around 3 percent. But that inflation component was only a small
contributor to the 12 percent TIPS returned.
A larger factor behind the bonds’ gains was a dramatic
decline in the bonds’ yields, after subtracting inflation. In
the industry, these are referred to as real yields, and they
supplied around 9 percent of the bond’s returns last year.
“We think there’s an underappreciation on the part of
investors about where those returns are coming from,” said
Stewart Taylor, a TIPS fund manager at Eaton Vance in Boston.
“Returns over past year or so as real rates have plunged have
been kind of spectacular, but when real rates rise, the losses
will be just as spectacular.”
Bonds have rallied strongly since 2009 as Federal Reserve
purchases, disappointments with U.S. economic growth and fears
over European debt contagion have fueled strong demand for
safe-haven U.S. debt.
Fed bond purchases, along with a commitment to rock-bottom
interest rates for at least the next two years, are seen by many
as the prime factor behind the dwindling yields, which otherwise
would be as much as 2 percentage points higher, based on
economic growth patterns.
TIPS prices are highly sensitive to yield shifts in either
direction.
An increase of 1 percentage point in the real yield over the
coming year would translate into a drop of around 8 percent in
TIPS prices, said Bill Irving, a TIPS portfolio manager at
Fidelity Investments in Boston. “That is a lot of volatility,”
he said.
“In the past year the price appreciation was far in excess
of what the inflation compensation was. If we swing the other
way and yields were to go back to just what they were a year
ago, it would likely overwhelm whatever inflation we had over
the next year,” Irving said.
NEGATIVE YIELDS
The risk that some investors will be burned on the debt is
even higher as the bonds have been trading with negative real
yields since 2010, meaning that investors are paying the
government to borrow from them.
The real yield of five-year TIPS, for example, has fallen to
negative 1.24 percent, from negative 0.82 percent at the
beginning of the year and negative 0.06 percent at the beginning
of 2011. The bonds first traded with a negative real yield in
October 2010.
“In previous episodes of rising interest rates, the income
from the TIPS was significantly higher than what they are today,
and so you had some cushion,” said Vanguard’s Wright-Casparius.
“Investors who are chasing returns at this particular
juncture are paying a premium and I think they have this
inflation view that needs to be tempered a little bit as being
totally protected against potential negative returns,” she said.
