A column published last Friday highlighted the risks known as "Treasury Inflation-Protected Securities Market in 2022." Facing the first major deflation in its 25-year history, investments intended to hedge against inflation quickly surrendered. Mid-term TPS fell 12% year over year, and their long-term counterparts fell even more.
Then comes the possibility of disaster. Perhaps the hint has fallen too far. This column looks at the issue from two perspectives: 1) as an investment and 2) as a tradable security. In the first case, the main question is: "If I stay with TPS for 10 years, am I happy with my decision?" Here's what he said. Second, the question is whether tips will be cheaper. If so, then there is no point in buying TPS as it may become less valuable soon.
Buy and hold
The first angle is easy to handle. Unusually, tips have obvious fixed income. The underlying mechanics are not easy to explain, as market movements affect the calculation (for example, a security issued with a positive real yield may have a negative real yield), but the TIPS yield is substantial after inflation. It is already known that it will be baked. (Not because of reinvestment risk, but close enough for Blogger.)
The current 10-year TIPS rate is 1.6%. Buy a newly issued 10-year TPS, store it in an electronic locker, and after ten years the security will return an annual inflation rate of 1.6 percent, as determined by the unadjusted version of the Consumer Price Index. (Again, this label is a long story, but very relatable.)
We can compare this figure of 1.6% to what 10-year Treasuries have historically achieved. I began my investigation in January 1960, when the 10-year Treasury began in 1953. From now on, I calculated the actual return you could pay each year for each decade, assuming the stock was bought at the beginning of the decade and held until maturity. So the bar labeled "1960" is the one bought in January 1960 and sold in January 1970. Represents a 10-year Treasury bond.
At first glance, TPS doesn't seem cheap. In three out of six decades, its natural investment rival, the conventional 10-year Treasury bond, has outperformed today's tips. Twice the result was the same. Only once, in the 1970s, did today's TPS exceed the real return that regular Treasuries eventually did.
Another view is happy. In the 1980s, 1990s and 2000s, conventional Treasuries performed well, but only because their yields exceeded 6.5% at the start of each period. This is no longer the case. Based on typical current Treasury bond yields, the 1960s and 2010s are a more relevant comparison. TPS was fully competitive at the time, reflecting unexpectedly high inflation.
Thus, 10-year notes are more attractive than their regular Treasury counterparts. It was not a year ago when their current production was negative, but the scale was used against it and there was no quote. (One could argue for the strategy of combining the two investments so that the guaranteed portion of the investor's future returns is nominal and inflation-adjusted, but that's a topic for another column.)
Next 12 months
Now consider whether TIPS will suffer further declines. To do this, you need to think about how tips will be provided. As mentioned earlier, TPS returns come from two sources: 1) inflation and 2) real output. Although inflation cannot be predicted in advance, we can calculate the expected rate by subtracting the actual TPS yield from the standard maturity Treasury. The rest of the market is waiting for inflation, plus or minus.
As expected, this measure of underlying inflation fluctuates significantly; After all, most people now see inflation as a bigger threat than they did three years ago. However, as the chart below shows, headline inflation has remained relatively stable. It fell each year during the two recessions of 2008 and 2020, but has consistently fluctuated between 1.5% and 2.5%.
While it is easy to understand how inflation changes, it is difficult to predict why actual TPS yields will change. Why would investors want a 1% real yield on a 10-year US Treasury bond, which means questions about credit quality won't affect its price at some point and should not be met much less at other times? After all, the group of investors does not change from year to year and the investment demand does not increase.
This chart is more dynamic than the previous one. From 2003 to 2010, this index (coincidentally) occupied roughly the same spot on the underlying inflation chart, fluctuating between 1.5% and 2.5%, but fell below 1% in 2010 and remained there until recently. Moreover, real income is significantly negative in both cases.
In general, genuine products found in TPS are highly volatile, as experts can only discover them after the fact. (Some observers warn that TPS could suffer if the Federal Reserve raises interest rates too quickly in 2021.) Real yields are higher today than in recent history. A decrease in real output is a positive sign for TPS as it raises their prices. But real yields remain low by pre-2010 standards – and who is the new default?
I only wrote about tips last week, partly because I was discussing fairness, but I've never been tempted to do so. Since this column began in 2013, real returns on TPS have always been less than 1 percent. Never Never Hence, TPS has become an attractive investment target. However, TPS remains risky for investors with liquidity needs as their real returns are likely to decline. Maybe they should stick to the money.
This article has been edited to note that actual TPS returns are not always negative since 2013. It was always less than 1%.