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What happens to TIPS if deflation occurs?
The principal is adjusted downward, and your interest payments are less than they would be if inflation occurred or if the Consumer Price Index remained the same. You have this safeguard: at maturity, if the adjusted principal is less than the security's original principal, you are paid the original principal.
What are the maturity terms for TIPS?
The maturity terms for TIPS are 5 years, 10 years and 30 years.
Click to enlarge.
TIPS were introduced in 1997. I've been buying them since 2000.
Where's the deflation in the CPI?
Where's the hyperinflation in the CPI?
At least so far, this has been a death of real yield story. It has been harder and harder to make money off of money.
May 9, 2008
The Death of Real Yields Revisited Yet Again
Click to enlarge.
I have added red arrows to help us know when the worst is over. Contrary to popular opinion, the third time was not the charm. Nor were the fourth or the fifth times apparently.
The 10 year real yield now sits at just 0.09%. As seen in the link, it fell to -0.03% on September 9, 2011. It literally fell into uncharted territory.
That's fear. The last trading day before the 10 year anniversary of 9/11 tends to do that. Are we done being afraid? I somehow kind of doubt it.
Source Data:
St. Louis Fed: CPI
7 comments:
Mark,
I continue to rely on/and appreciate your TIPs info. I-bonds made sense to me, and I started buying in 2002, and pretty much do the full allocation each year...and have never regretted it. But, TIPs, well. Too late perhaps I have seen my error. I am going to bid on the reopened TIPs on 9/22...a smallish amount, 10k. I am not liking any money markets at this point, and I considered very seriously your earlier answer that TIPs, held to maturity might outperform CDs. At the moment, safety is all I am looking for...things look very dicey to me.
all best,
Mark wrote "I've been buying them since 2000."
Still can't buy any TIPS under 10 years on the secondary market right now!
Also, out in mutual fund and ETF land, there are a ton of people with no clue that the principal can be adjusted downward in the event of deflation. A lot of people think TIPS are a free lunch bond... not much of a return, but no risk of losses ever. And it just isn't so...
BTW, if you plot the long TIPS ETF (LTPZ) against Gold, you find that the correlations are nearly exact, but Gold makes larger moves (higher "beta", so to speak). And gold doesn't have its upside capped the way TIPS do. Of course, it also has more downside risk, especially now.
fried,
For what it is worth, 10k is the exact amount I'm planning to buy in January's auction.
I'll take whatever the market gives me.
According to bankrate.com, you could get a 2.25% 5 year CD right now and hope that inflation remains low or falls. You'd also be hoping that rates will be no worse 5 years from now.
I generally try to avoid hope, especially when I'm valuing safety.
Wisdom Seeker,
A lot of people think TIPS are a free lunch bond... not much of a return, but no risk of losses ever. And it just isn't so...
No joke!
Check this out. I stumbled upon it a few days ago. I was trying to figure out how happy investors were sitting in short-term TIPS funds. Did they even realized that TIPS rates were pretty much guaranteed to lose money no matter what happens (due to negative interest rates at that duration)?
September 4, 2009
Rates
When interest rates start to rise we should sleep very soundly.
If you require higher interest rates to sleep soundly and you are sitting in a bond fund, then you are more than a bit confused.
I rode TIP down in 2008. I most certainly was not sleeping soundly. That said, the cheaper it got the more I liked it. There were no thoughts of panicking at the bottom.
Even a 1-5 year TIPS bond fund could easily see big losses if deflation strikes again.
BTW, if you plot the long TIPS ETF (LTPZ) against Gold, you find that the correlations are nearly exact, but Gold makes larger moves (higher "beta", so to speak). And gold doesn't have its upside capped the way TIPS do. Of course, it also has more downside risk, especially now.
I posted my thoughts on this recently. I believe gold acts a bit like a TIPS bond of infinite maturity.
That would explain why gold makes larger moves.
Here's one more risk the "Rates" investor doesn't grasp.
If real rates rise because investors flee US assets and/or we simply offer too much debt for the markets to absorb then TIPS investors can take serious damage. That's especially true for investors sitting in TIPS bond funds who do not have the luxury of holding their investments to maturity.
Where's the deflation in the CPI?
Stag,
There's good deflation and bad deflation.
Fortunately, the deflation has been CONtained to the highly leveraged household balance sheet item of housing!
Thanks to Bernanke (uber "student" of the GD), we dodged the bullet of a falling CPI (so far anyway). Whew!
mab,
The Fed knows that easy credit policies can cause problems. The guilt of falling prices must be overwhelming.
That's why they are using easy credit policies to boost food and energy prices right now. It's their way of compensating.
The Fed always has our back.
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