The Two-Year Rally in TIPS May Be Over

As Washington flooded the economy with money to fight the worst slump since the Great Depression, inflation fears helped make Treasury Inflation-Protected Securities (TIPS) the best-performing government bonds over the past two years. Now, with few signs of higher inflation in sight, traders say TIPS may be poised to fall.

When you buy TIPS, the amount you own—and receive interest on—is adjusted annually to reflect the change in consumer prices. That's the inflation protection. You don't have to worry about deflation, because the principal can't fall below the bonds' face value. As inflation-wary investors snapped up the securities over the past two years, their prices rose sharply. TIPS returned a total of 17.2 percent from January 2008 through Jan. 25, 2011, reflecting interest income and price increases. That compares with a gain of 2.1 percent for a broad mix of Treasuries, Bank of America Merrill Lynch (BAC) indexes show.

Buying TIPS today may not be as lucrative. While the economy has shown signs of recovery, prices of goods and services have not been rising nearly as rapidly as some investors feared. One reason is that unemployment is still high, which reduces the pressure on companies to increase wages—and makes it harder for them to raise prices.

The current yields on 10-year TIPS show that bondholders expect the consumer price index to increase 2.18 percentage points a year on average over the life of the debt, well above recent readings. Inflation rose 1.5 percent in 2010 and is forecast to climb 1.7 percent this year, according to a Bloomberg survey of more than 60 economists. "We're nowhere near any inflationary type of levels," says Gary Pollack, who helps oversee $12 billion as head of fixed-income trading at Deutsche Bank's private wealth unit in New York. "There's a lot of slack in the U.S. economy, especially in the labor market. It's too soon to get too bullish on TIPS."

The lack of inflation has diminished demand for TIPS. When Treasury sold a record $13 billion in 10-year TIPS on Jan.20, it received the fewest bids per dollar of debt sold since April 2009. Prices on TIPS maturing in July 2020 fell after the auction, boosting the yield to 0.99 percent as of Jan. 24 (yields rise when prices fall). At the same time, the yield on the 10-year Treasury note jumped 8 hundredths of a point to 3.41 percent, according to BGCantor Market Data.

Even facing weaker demand, the government will issue more TIPS as it increases sales of all bonds to fund the federal budget deficit, which is projected to top $1.2 trillion for a third year. Treasury will auction $120 billion to $125 billion of TIPS in 2011, after boosting issuance by 48 percent, to a record $86 billion last year, according to Barclays (BCS) and Credit Suisse (CS) estimates. The increased supply may put pressure on prices, dampening returns.

Some strategists think inflation protection is still worthwhile. Commodities including corn, cotton, and crude oil have risen 24 percent since August (through Jan. 25), as measured by the Thomson Reuters/Jeffries CRB Index. U.S. consumers haven't felt much of an impact so far. Retail food costs rose 1.5 percent last year and will gain as little as 2 percent in 2011, the U.S. Agriculture Dept. estimates, though grocers from Jacksonville (Fla.)-based Winn-Dixie Stores (WINN) to SuperValu (SVU) in Eden Prairie, Minn., have said they plan price increases. Commodities will keep rising, according to a Bloomberg survey of more than 100 analysts and traders.

And the economy continues to pick up speed. Gross domestic product will grow 3.1 percent in 2011 and 3.15 percent in 2012, according to the median forecasts in a Bloomberg survey. The median growth forecasts in October were for 2.4 percent expansion in 2011 and 3 percent in 2012. "Where we find value [in TIPS] is as an inflation-insurance play," says Michael Pond, co-head of interest rate strategy at Barclays. He notes that the Federal Reserve remains committed to its policy of bond purchases, known as quantitative easing, to boost the economy. "The Fed is keeping its foot on the accelerator, despite the fact that data has been coming in better the past couple of months."

The bottom line: Inflation fears helped push up the prices of TIPS over the past two years. With little inflation in sight, the rally may not continue.

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