From p 18, ETF for Dummies, 2nd Ed (2011), by Russell Wild:
Such bonds do, however, carry interest-rate risk, and another risk that’s unique to them: deflation risk. If consumer prices start to drop, your inflation adjustment will be worth zero, and you’ll be left holding the lowest yielding bond in the land."
From p 2 of 5, http://www.vanguard.com/pdf/flgpt.pdf:
Deflation—an actual fall in consumer prices—is a TIPS investor’s nightmare scenario. Nominal Treasury bonds would rise in value as market yields declined in response to deflation. Although deflation likely would reduce real interest rates as well,
♦ this effect would probably be more than offset by the downward inflation adjustment to TIPS’ principal ♦.
The result could be a
fall in the market price of TIPS. Accrued increases in principal due to prior inflation would, to a point, be offset: For example, a $100,000 par TIPS whose principal value had risen to $105,062 after two years of 2.5% inflation would, after a year’s deflation of 2.5%, decline to $102,435. Interest payments would fall too: Given a coupon of, say, 2.27%, annual payments would shrink from $2,385 to $2,325. If deflation continued, income would keep falling as the deflation-indexed principal value was adjusted lower. The only good news in such a scenario is that, in theory, the TIPS investor would be
no worse off, since the “real” value of principal and income would be unchanged.
1. Am I right that deflation nullifies any inflation adjustment for TIPS? So a TIPS holder would earn just the coupon rate?
2. How's the bolded (in Wild's excerpt) true?
3. Does the bolded jar with the clause that I surrounded with ♦, in the Vanguard PDF? Vanguard claims some inflation adjustment, but Wild alleges none?
4. How does all this cause
fall in the market price of TIPS? I realise that amid deflation, there's no need to hedge against inflation. Still, why will investors' demand for TIPS diminish? TIPS will still offer interest. Also, due to deflation, cash tomorrow > cash today; so holding cash provides a positive return?
5. Why'd TIPS
no worse off than bonds without inflation protection?