TIPS Underperform Straight Treasurys for Third Consecutive Year.
TIPS posted losses in the last three quarters of 2015, bringing the total loss for the year to 2.14%, meaningfully worse than the 0.87% gain in comparable maturity straight Treasurys. The most likely cause of the underperformance was the decline in inflation expectations, due to the drop in the price of oil. When expectations for inflation fall, investors will expect a higher current yield on TIPS to justify holding them versus straight Treasurys. Accordingly, bid prices on TIPS declined in each of the last three quarters.
Most of the price movement in all Treasury securities is driven by longer maturity securities. Long-term TIPS and Treasury returns are more sensitive to changes in interest rates and expectations.
Changes in the CPI and expectations of such changes explain most of the quarter-by-quarter fluctuations in TIPS performance. For the past 18-24 months, the headline CPI, upon which the inflation adjustment is based, has been easing, due mostly to falling oil and natural gas prices.
For the year just ended, the CPI increased by 0.1%. That compares with an average increase of about 2% over the prior five years. The low rate of inflation in the U.S. economy has been sustained by both the decline in the price of oil and the strong dollar, which has reduced the cost of imports. With labor markets poised to tighten, oil near a bottom and the dollar near a top, inflation should pick up before too long. In theory, a rise in inflation expectations should widen the spread between straight Treasury and TIPS yields.
Optimism about a return to normalcy for the CPI helped TIPS post a positive return of 1.0% in the 2015 first quarter. Since then, however, they have lost ground, falling 1.3% in the second quarter, 1.4% in the third quarter and 0.5% in the fourth quarter.
First Quarter Performance
TIPS earned an average total return of 1.0% in the 2015 first quarter, less than the 1.9% gain on straight Treasurys. All maturities in both TIPS and straight Treasurys saw gains.
The average TIPS yield fell 101 basis points from the 2014 fourth quarter to -0.35%, a significantly greater move than the 18 basis point decline in the Treasury yields. As a result, the yield spread widened from 100 basis points to 183 basis points, reflecting an increase in inflation expectations.
Second Quarter Performance
In the 2015 second quarter, TIPS posted an average loss of 1.3%, better than the 2.3% loss on comparable maturity Treasurys. Short-term TIPS earned a positive return of 0.7%, 30 basis points better than straight Treasurys; but intermediate and long-term TIPS posted losses. Most of the losses for both TIPS and Treasury’s were concentrated in longer-maturity securities.
The average yield on TIPS became less negative in the quarter, rising to -0.06% from -0.35% or by about 30 basis points from the 2015 first quarter. Likewise, Treasury yields rose by about 30 basis points to 1.79%. Better returns on the short end were driven by a rebound in the CPI. But the spread between TIPS and straight Treasurys remained flat at 184 basis points. Thus, most of the losses on both TIPS and Treasurys were apparently driven by rising interest rates (and the expectation that the Fed would soon end its policy of holding short-term interest rates near zero).
Third Quarter Performance
In the third quarter, TIPS posted a loss of 1.4%, much worse than the 2.4% average gain in straight Treasurys. The divergence in performance probably reflected flight to safety buying of Treasurys, in response to the sharp drop in the stock market.
During the third quarter, TIPS yields rose again, by 60 basis points on average, while yields on comparable maturity Treasurys fell by 18 basis points to 1.61%. This time, lower inflation expectations were reflected by the decline in the breakeven spread.
It is difficult to reconcile the rise in TIPS yields against the decline in spreads. One possible explanation: returns on short-term TIPS swung decidedly negative during the quarter, which probably reflected a sell-off due to expected continuing oil-driven declines in the CPI.
Fourth Quarter Performance
During the quarter that the FOMC officially ended its zero-rate Fed Funds policy, TIPS posted a loss of 0.52%, but that was roughly half of the loss of 0.98% recorded on comparable maturity straight Treasury securities. TIPS yields were essentially flat, while straight Treasury yields increased by nearly 20 basis points. As a result, the breakeven spread widened a bit, from -0.95% to -1.28%. All of this market action is probably attributable to the Fed interest rate move and a modest market rethink of the outlook for both inflation and interest rates.
2015 Full Year TIPS vs. Treasurys Returns
In what was a generally a tough year for stocks, comparable maturity straight Treasury’s managed to eke out a gain of 0.87%, while TIPS posted a loss of 2.14%. Investors apparently avoided TIPS as expectations for inflation declined. TIPS yields increased by 50 basis points, while average Treasury yields increased by a measly 4 basis points. Thus, the breakeven yield fell by about 45 basis points to -1.28%, the lowest since the financial crisis.
Although it is difficult to predict the course of interest rates during 2016, it is probably an easy bet that the breakeven yield will not remain this low for long.
In the chart above, I have increased the y-axis bands (cutting off the high and low yield on the shortest maturity TIPS) in order to show more clearly how the TIPS yield curve has shifted over the past 12 months. From December 31, 2014 to March 31, 2015, the TIPS yield curve shifted downward, as both TIPS and straight Treasurys rallied. From there, it was all downhill for TIPS, as they underperformed Treasurys in the second and third quarter and still posted a slight loss in the fourth quarter (but a better relative performance than Treasurys). Thus, after the initial downshifting during the first quarter, the TIPS yield curve ratcheted upward slightly in each successive quarter.
Please note that I typically exclude new issues from my calculations for the market because these tend to have outsized gains and losses during their first year, which can sometimes skew the performance data.
January 26, 2016
Stephen P. Percoco
Lark Research, Inc.
16 W. Elizabeth Avenue, Suite 4
Linden, New Jersey 07036