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.
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 10% 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 a 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 the ultimately a duration lesson for Tips holders which was perhaps inevitable given the low starting point for yields. You have not see 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.