3

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?

3

During late 2008, the US set records for deflation, and the TIPS ETFs fell as a result. These TIPS ETFs didn't fall as far as it could've, because interest rates fell and blunted some of the damage.

This is because TIPS' coupon is based upon the inflation rate. TIPS are actually very speculative instruments because of the wild swings in the inflation rate.

The perpetuity is the easiest bond to manipulate:

P = i / r

Where P is the price of the bond, i is the bond's interest payment , and r is the market interest rate. Normally, i is held constant, so that the relationship is primarily between P and r thus easy to see.

TIPS complicates this becausei is no longer constant. i was the fixed coupon, but now is also a variable coupon based upon the CPI which is actually a little faster than true inflation I might add.

If the coupon i falls due to a deflation, P the price also falls. If the coupon i rises due to an inflation, P the price also rises.

In 2008 since r also fell, P partially rose as a result.

In short, real rates rose during the 2008 collapse and then quickly fell. TIPS are tied to the real interest rate not the nominal or undeflated interest rate, so that is the "real" rate that affects them.

Your Answer

By clicking “Post Your Answer”, you agree to our terms of service, privacy policy and cookie policy

Not the answer you're looking for? Browse other questions tagged or ask your own question.