(Bloomberg). During the worst recession in US history, investors sought refuge from Wall Street. Treasuries provide extra compensation to help keep pace with rising consumer prices.
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The brutal reality of bond market math destroyed that sense of safety.
The Federal Reserve’s unusually steep interest-rate hikes caused the securities to tumble severely along with the rest of the bond market — so deeply, in fact, that the price drop more than erased the extra payouts tied to the soaring inflation rate.
Despite bonds recovering over the past 2 months due to speculation that the Fed will slow rate hikes, the Bloomberg Index of Treasury Inflation Protected Securities (or TIPs), is set for a loss in excess of 11% this fiscal year. That’s the worst since they were created in the 1990s and only slightly smaller than the hit taken by standard Treasuries.
The drubbing caused a pullback from the securities for much of the year, with investors effectively seeing them fail just when they were needed the most — like an insurance policy that didn’t payout when disaster struck.
“The TIPs product is a not a pure play inflation hedge,” said George Goncalves, head of US macro strategy at MUFG. “You might think you are diversified, but TIPS have the same underlying interest rate risk exposure as other bonds. This was the final lesson for TIPS holders, which was probably inevitable due to the low yields. You have not see a year like this in decades.”
The securities illustrate how broadly the abrupt-end of the Fed’s easy-money policies roiled every niche of US financial markets, even those seen as the most risk-free havens.
TIPs can be compared to other US government bonds. However, the interest rates are set at the time they are sold. The key difference is that principal — or what a bondholder is owed when it matures — is adjusted upward to keep pace with the consumer-price index. Because the principal is used to calculate interest payments twice a year, they will also increase if inflation is rising.
If the bonds are held until maturity, investors are guaranteed to be compensated. It does not provide a buffer against losses when prices plummet due to interest-rate rises, as happened this year with the Fed’s most aggressive cycle in monetary policy tightening ever.
The yield on 10-year TIPs rose from a negative 1.25% in November 2021, to 1.82% in October as investors became more confident about the Fed’s ability to lower inflation.
The swing “highlighted the fact that investors had paid so much for inflation protection,” said Jonathan Duensing, head of fixed income at Amundi US.
The sharp rise in yields since the post-pandemic lows has revived Wall Street demand for bonds amid speculation that inflation will fall from its peak and that the Fed will stop raising rates by mid-2023. That’s also true for TIPs, which delivered positive returns over the last two months and may continue to gain, especially if inflation remains more persistent than expected.
Jay Barry, the co-head of US rates strategy at JPMorgan Chase & Co., said the break-even rate for intermediate maturity TIPs — or the inflation rate over the life of the bond needed for the returns to top those on typical Treasuries — now “looks cheap.”
Monday’s breakeven was 2.35%, which is slightly lower than the 2.55 % earlier in this month. That’s well below the current inflation rate: economists expect the Labor Department on Tuesday to report that the consumer price index rose at a 7.3% annual pace in November, down only slightly from the 7.7% a month earlier.
Gargi Chaudhuri is the head of iShares’ investment strategy for Americas at BlackRock Inc. She believes that inflation will remain above pre-pandemic levels due to supply and labor shortages. She said the current prices of 10- and 30-year inflation-protected Treasuries provides “an opportunity for clients to buy insurance as inflation stays higher than what the market currently expects.”
“Getting inflation down to 5% is the easy part, getting back to 2% is the real battle and that will take some time,” she said.
Given this year’s track record, though, investors may be in no rush to shift back into TIPs, especially if a slowdown in economic growth strengthens the conviction that the Fed will win its battle against inflation.
Getting “bullish sentiment among retail ETF type investors back towards Tips likely requires some kind of inflation scare,” said Amundi’s Duensing.
“As inflation declines and investors realize that TIPs interest-rate exposure overwhelmed inflation compensation in 2022, some may continue to withdraw assets from the product,” Ira Jersey, chief US interest rate strategist at Bloomberg Intelligence wrote. Such a retreat “could pose a challenge to a very sustained rally.”
(Updates five-year breakeven, chart)
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