by James Kochan, Wells Fargo Asset Management
If the Federal Reserve (Fed) raises the federal funds rate several times in the months ahead, there is probably a good chance that yields could rise in most segments of the Treasury market and, therefore, total returns could be negative. Because past time periods in which the Fed tightened were periods in which inflation was increasing, some market observers and strategists are suggesting that Treasury Inflation-Protected Securities (TIPS) should perform well even if Treasury yields rise. The rationale: The prospect of somewhat higher inflation would be expected to increase the demand for, and enhance the performance of, TIPS. History shows, however, that returns from TIPS are closely correlated with returns on the nominal Treasuries. Historically, if returns on Treasuries turned negative, returns on TIPS were likely to do the same.
Since TIPS were introduced in 1997, there have been seven periods in which Treasuries produced significantly negative total returns. TIPS produced positive returns in only one of those periods. That was February to December 1999, when the yield on the benchmark 10-year Treasury note rose from 4.60% to 6.50% and the Treasury market recorded a -3% total return. The yield on 10-year TIPS rose only 60 basis points (bps; 100 bps equals 1.00%), and the TIPS market produced a return of 1.2%. TIPS yields were in the 3% to 4% range back then, and the inflation-related increases in principal values were in the 2.0 to 2.5% range. The combination of high coupon income and the principal adjustments kept returns positive despite the drop in market values.
In five of the six other periods, TIPS yields rose almost as much Treasury yields, and in one instance (2003), they rose more than Treasury yields. As a result, returns on TIPS were negative and not substantially different from the negative returns on the nominal Treasuries.
The fact that TIPS are currently relatively cheap versus the nominals is sometimes cited as a reason why TIPS could withstand a rise in Treasury yields. The current 10-year TIPS to 10-year note spread of -150 bps is substantially less than the long-term average spread of approximately 225 bps. (That average excludes the 2008–2009 period when TIPS spreads exploded to extreme levels.) In those earlier periods of negative returns, however, relatively narrow spreads did not prevent TIPS yields from rising as much as Treasury yields. For example, in the 2015 episode, the 10-year TIPS spread was relatively narrow—170 bps and TIPS yields rose more than Treasury yields. The TIPS market performed worse than the Treasury market.
The extremely low yields and low inflation prevailing today are additional headwinds for TIPS’ future performance. Among the periods examined here, TIPS returns were the poorest in 2010, 2013, and 2015, when yields were very low. In 2010 and 2015, TIPS performed worse than the nominal Treasuries. Today, yields are still unusually low and the inflation adjustment is only around 1%. That combination may result in negative returns if Treasury yields were to rise over the next 12 months. As an example, if the yields on the 10-year note and the 10-year TIPS were to rise 50 bps over the next 12 months, the note would return -2.5% and the TIPS would return -3.5%, using a 1% inflation assumption. If the inflation assumption is increased to 2%, the TIPS return becomes -2.6%.
Conclusion
It may sound appealing to own TIPS in a period of rising rates because the potential for inflation mitigation might strengthen demand enough to avoid negative returns. However, history does not support that argument. If Treasury yields were to rise, I believe it is likely that they could pull TIPS yields up with them. In that event, the very low yields and low inflation adjustments probably would not be sufficient to offset the price declines, and total returns are likely to be as negative as on comparable nominal Treasury notes and bonds.
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