This year, however, the winning streak has faltered a bit as inflation expectations have shifted radically. As the United States economy has slowed, European debt worries have revived and oil prices have fallen back from their recent highs, inflation expectations have moved downward.
For Treasury inflation-protected securities, or TIPS, that has not been good news.
“TIPS have gone through a period where just about everything has gone right for them,” said Robert Johnson, director of economic analysis at Morningstar. “Now the situation has changed, and they are looking quite expensive.”
TIPS pay interest on a principal amount that rises with inflation, so investors are compensated as consumer prices rise. When the securities mature, the investor is paid the adjusted principal amount or the original principal, whichever is greater.
Investors have poured money into TIPS, particularly since last August, amid concerns that the Federal Reserve’s plan to buy $600 billion in Treasury securities would fuel inflation. Those fears grew even more frantic early this year when turmoil in the Middle East and North Africa drove crude oil prices well over $100 a barrel, and gasoline prices in the United States began to climb.
According to EPFR Global, which tracks fund flows, investors added more than $7 billion to inflation-protected bond funds in the first half of this year, roughly equaling the amount for all of 2010.
The big swings in inflation expectations have been most evident in the so-called break-even rate — which is the difference between yields on 10-year Treasury notes and 10-year TIPS and reflects trader expectations for consumer prices over the life of the debt. That rate climbed to a high of 2.67 percent in April, just as crude oil prices peaked at around $114 a barrel, from 1.5 percent last August.
But in May, as signs of an economic slowdown appeared and investors began to anticipate an end to the Fed’s bond-buying spree, inflation expectations collapsed. As measured by the break-even rate, expectations for consumer price inflation dropped to 2.14 and the TIPS market stumbled.
TIPS funds returned just 0.3 percent in May, before rebounding in June as worries eased about Greek debt and a sustained slowdown in the United States economy.
For the second quarter, inflation-linked bond funds returned about 3.1 percent according to Morningstar, compared with 3.6 percent for funds that invest in regular long-term government bonds.
Over longer periods, however, TIPS have sometimes outpaced the returns of regular Treasury funds. Over the last five years, inflation-linked bond funds have returned 6.36 percent, annualized, compared with 6.04 percent for intermediate government debt funds and 7.4 percent for long-term government bond funds.
“The TIPS market clearly got a bit exuberant going into the spring,” said Daniel O. Shackelford, manager of the $387 million T. Rowe Price Inflation Protected Bond fund. “Over the last several weeks, the market has made an adjustment to more modest inflation expectations,” he said.
The T. Rowe Price TIPS fund returned 3.3 percent in the quarter, after gains of 6.29 percent in 2010 and 10.43 percent in 2009.
DESPITE the recent adjustment, analysts say TIPS remain expensive, particularly those with shorter maturities. Bond prices and yields move in opposite directions, and TIPS maturing in five years, for example, yielded a negative 0.37 percent at the end of the second quarter. That compared with a 1.76 percent yield on a regular five-year Treasury note. Ten-year TIPS yielded 0.69 percent, compared with 3.16 percent for noninflation-linked 10-year Treasury debt.
Managers of TIPS funds say the inflation protection offered by TIPS makes sense for a portion of a portfolio.
“If you buy a two-year Treasury note yielding 40 basis points while inflation is running at 2 percent, that is wealth destruction,” Mr. Shackelford said. “TIPS may not be a formula for building wealth; they will do what they were constructed to do, which is to compensate you for increases in consumer prices.”
Some money managers say they are shifting into the longer-term end of the TIPS market, where yields for 30-year maturities were 1.7 percent as of the end of June.
“We’ve been moving out of the intermediate sector of TIPS and buying the long end,” said Martin Hegarty, co-head of global inflation-linked portfolios at BlackRock, the New York-based money manager, which oversees $3.6 trillion in assets. Mr. Hegarty said purchases of intermediate-term TIPS, those of 5 to 10 years, by foreign central banks had helped to depress yields in that sector.
The $4 billion BlackRock Inflation Protected Bond fund gained 2.6 percent in the second quarter and 4.66 percent this year through June.
Still, analysts said the current pricing of TIPS should raise at least one red flag. TIPS may be inflation-protected and backed by the full faith and credit of the United States, but they are far from being risk-free.
“If the Fed were to make any pre-emptive move against inflation, TIPS could get killed,” said Mr. Johnson at Morningstar. “People tend to think TIPS have no risk, but if you sell them before maturity, or if you own a fund that it weighted with longer-term maturities, they can have substantial risk.”
Fund managers say that while these problems are real, TIPS may still be useful.
“Investors certainly should not judge TIPS by taking a backward view of how they have performed,” said John W. Hollyer, a manager of the $35 billion Vanguard Inflation-Protected Securities fund, which returned 3.4 percent in the second quarter. “They are not a risk-free asset because they have a high sensitivity to changes in interest rates. But if inflation makes a sudden move upward, you will be compensated, and that’s important.”
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