Inflation Was So Bad That It Even Crushed Inflation-Linked Bonds

(Bloomberg) — As the US economy veered toward the biggest inflation shock in four decades, investors flocked to the one corner of Wall Street that seemed a sure-fire refuge: Treasuries that provide extra compensation to keep up with rising consumer prices.

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Then the brutal reality of bond-market math shredded 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.

Even with the bonds rebounding over the past two months on speculation the Fed is poised to slow its rate hikes, the Bloomberg index of Treasury Inflation Protected Securities, or TIPs, is headed for a loss of nearly 11% this 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 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 ultimately a duration lesson for TIPs holders which was perhaps inevitable given the low starting point for yields. You have not seen 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 are similar to other US government bonds, with the interest rates fixed at the time of sale. 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. The twice-yearly interest payments are based on that principal, so they also grow as well when inflation is on the rise.

The arrangement guarantees that investors will be made whole if the bonds are held to maturity. But it provides little buffer from losses when prices plunge because of interest-rate increases, as they did this year when the Fed embarked on the most aggressive cycle of monetary policy tightening since the 1980s.

As interest rates rose and investors grew more confident that the Fed will bring down inflation, the yield on 10-year TIPs surged from as low as negative 1.25% in November 2021 to 1.82% by late October.

The swing “highlighted the fact that investors had paid so much for inflation protection,” said Jonathan Duensing, head of fixed income at Amundi US.

That steep jump in yields from post-pandemic lows has rekindled demand for bonds in general across Wall Street amid speculation that inflation is coming down from its peak and the Fed will stop raising rates in 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.”

The breakeven eased a little on Monday to about 2.35% for five-year TIPs, extending a drop from 2.55% earlier 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, head of iShares investment strategy for the Americas at BlackRock Inc., anticipates that labor shortages and supply constraints will keep inflation over pre-pandemic levels. 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)