A ‘Perfect Storm’ Hits TIPS Funds; Rising interest rates and falling inflation expectations batter Treasury inflation-protected securities

October 6, 2013, 4:50 p.m. ET

A ‘Perfect Storm’ Hits TIPS Funds

Rising interest rates and falling inflation expectations batter Treasury inflation-protected securities

TOM LAURICELLA

Owners of inflation-protected-bond funds have learned a painful lesson this year, and it’s one well-heeded by all investors: Understand how an investment will perform in unlikely scenarios, not just likely ones. These funds, which are usually purchased as a hedge against spiking inflation, own government bonds designed to adjust their payouts as inflation rises and falls.Inflation hasn’t been a front-burner concern for investors this year, with the government’s consumer-price index rising just 1.5% in the 12 months through August.

Meanwhile, so far this year through Sept. 30, funds in the $93 billion category lost an average of 6.3%, which has them on course for the worst year since 1990, according to Morningstar Inc. “The magnitude of the losses surprised a lot of investors,” says Michelle Canavan Ward, an analyst at Morningstar.

Trouble for TIPS

The most commonly held bonds in this group are Treasury inflation-protected securities. TIPS offer coupon payments and a value at maturity that change along with the CPI.

Normally inflation is the mortal enemy of fixed-income investors, and TIPS can help offset the damage by paying holders more as inflation rises. But back in 2009, this column outlined two scenarios in which TIPS could inflict meaningful losses: One was an extreme rise in inflation. The other was having interest rates rise while inflation falls.

This year brought a variation of that second scenario: Rates rose and inflation expectations fell.

In May, Federal Reserve Chairman Ben Bernanke signaled the Fed could begin scaling back its easy monetary policy. In a sharp selloff, the yield on the U.S. Treasury 10-year note rose from 1.6% to a high of 3% in early September, before ending the month at 2.6%.

One problem is that most TIPS funds tend to hold longer maturities than many other classes of bond funds, which makes them more vulnerable to changes in interest rates. The average duration for inflation-protected funds is 6.5, according to Morningstar. That means that all other things being equal, a one-point rise in interest rates would inflict a 6.5% loss on the value on the average fund’s portfolio. In contrast, intermediate-term bond funds have an average duration of 5.0.

Dangerous Expectations

At the same time this summer, inflation expectations headed lower. The reason was that investors believed the Fed was set to pull back on its support for the economy at a time when economic growth was still weak, a potentially deflationary move.

Because market prices for TIPS adjust to inflation expectations, “they are very sensitive to Fed actions or perceived Fed actions,” says Mihir Worah, head of real-return strategies at Pacific Investment Management Co., or Pimco.

Mr. Worah says the decline in TIPS was magnified by heavy selling by hedge funds that had bought large holdings of TIPS with borrowed money.

“We got hit by a perfect storm over the last three months of things that were unlikely to happen, but were clearly in the realm of possibility,” he says.