Hidden Inflation Risks Lurks in Inflation Indexed U.S. Treasuries
There is hidden risk that U.S. Treasury Inflation Indexed Bonds (TIP’s) won’t work as intended and hold their value during inflation. TIP’s are very interesting because they are (hypothetically) a hedge against inflation. TIP’s are indexed to inflation. If inflation returns then interest rates will rise, which reduces the value of a bond. However because TIP’s are indexed to the CPI measurement of inflation then hypothetically they would have their payments adjusted to compensate for inflation. Since (in theory) interest rates go up with inflation, then the bond holder would in theory be protected. However, when inflation returns the Federal Reserve will raise the “real rate” of interest to higher than normal levels and since TIP’s are not indexed for “real rate increases” then they may decline by 20 to 30% in value.
The “real rate” means the rate you get after subtracting inflation from the yield on a bond. There were times when Paul Volker ran the Fed from 1979 to 1986 that “real rates” were about 4% to 7%. Today the “real rate” for a ten year TIP is 0.41%. So if inflation comes back then the real rate would probably go up to 4% or more as the Fed responds to inflation. Normally 10 year TIP’s have a real rate of about 2.5%, compared to today’s rate of 0.41%. If things return to normal then a ten year TIP’s investor would lose about 17%. This assumes the bonds would be discounted in price by the change from a real rate of 0.41% to 2.5%, which is 2.09% a year discount compounded over ten years. If the real rate went up to 4% from 0.41% a 10 year TIP would lose about 30.6% of value.