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TIPS,,,,, can anyone explain price decline YTD

If the fears of not transient inflation and higher interest rates are an environment that’s has SCHP off 3.13% YTD, what might happen if inflation were to diminish and rates were flat? Is the decline related to the portfolio duration of 7.70 and the price is reacting as any other bond fund to higher rates? Again,,,, how would a TIPS fund respond if rates were to go down? By comparison,,,IEF,,,,, a 7-10 year Treasury fund with a duration of 8.10 is off 2.61 YTD. I know that TIPS are currently expensive but I can’t figure out why they would be losing value now. Of course I know that 19 days is not meaningful but I feel stupid that I have a major position in something I clearly don’t understand at all. Any ideas? thanks in advance.

Comments

  • edited January 20
    Note the comment by Sonai Desai in my recent Barron’s Roundtable post (Quotable Quotes.)
    It’s second up from the bottom.

    I’ve avoided owning TIPS (except for a few short duration ones) because they are misunderstood by many and I can’t get a good read on their risk / reward profile myself. Putting them into a mutual fund subject to inflows and outflows further clouds the issue. Think of it this way: Foremost, you are buying a Treasury bond. Secondly, you are getting a certain amount of inflation protection along with that bond.
  • edited January 20
    TIPS have higher durations than Treasuries of comparable maturities, so they are hit worse from rising rates. Almost 25% of TIPS are held by the Fed, a price-insensitive buyer. And TIPS funds behave quite differently from individually held TIPS to maturity There is confusion on how the TIPS funds report 30-day SEC yield - some report only real 30-day yield, others add CPI to it.

    Many TDFs do include TIPS. Vanguard TDFs switched from IT-TIPS (too volatile) to ST-TIPS (to capture most of the inflation effects) years ago.

    (Edited post from another MFO thread)
  • Thanks gentlemen. I did switch to STIP for the shorter duration. I am a buy and hold guy and comfortable with my 35% equity allocation . It’s the other 65% that is driving me crazy. I suspect this is going to be a tough year for “the other.” I am not afraid of cash in the short term.
  • Some of my allocation / alternative funds hold TIPS. I’m fine with that as a diversification strategy. The managers understand what they’re doing. I wouldn’t.
  • see also Lewis B posts and links from a couple weeks back
  • msf
    edited January 20
    TIPS have higher durations than Treasuries of comparable maturities, so they are hit worse from rising rates.

    That seems a little odd. Do you have a source?

    The relationship between inflation adjusted (real) durations and nominal durations is somewhat complex. To simplify matters, we can assume the Fisher hypothesis holds literally:
    The Fisher hypothesis, which states that nominal interest rates rise point-for-point with expected inflation, leaving the real rate unaffected, is one of the cornerstones of neoclassical monetary theory.
    Barsky, The Fisher Hypothesis and the Forcastability and Persistence of Inflation, Journal of Monetary Economics 19 (1987).

    That is, real rates don't change; nominal rates change in lock step with inflation. If inflation goes up by 1%, nominal rates go up by 1%. The real rate doesn't change. Since TIPS adjust yield for inflation, their prices should change only as a result of changes in real rates, which by assumption are nonexistent. Thus zero duration.
    [Laatsch and Klein] confirm that TIPS bonds have zero sensitivity to changes solely in expected inflation. By changes solely in expected inflation, we mean that the real rate remains unchanged and the nominal rate changes in accordance with the established Fisher [Publ. Am. Econ. Assoc. 11 (1896)] effect. [They] show that the first derivative of the TIPS price [i.e. duration] is zero whenever the real rate is held constant.
    Laatch and Klein, The Nominal Duration of TIPS Bonds, Review of Financial Economics Vol 14, Issue 1 (2005)

    They go on to say that even relaxing the Fisher hypothesis (so that real rates change) "if expected inflation changes ... zero-coupon TIPS prices ... will change by a smaller percentage than will zero-coupon ordinary Treasury bonds."

    Shorter duration for zero TIPS than for ordinary (nominal) zeros.

    Here's PIMCO's "translation": TIPS should perform better in a rising interest rate environment than conventional Treasury bonds because their inflation adjustments provide better price protection, but only when rates are rising as a result of increasing inflation.
    https://www.pimco.com/en-us/resources/education/understanding-treasury-inflation-protected-securities
  • Duration is present-value-weighted timing of bond cash flows. So, as off-the-run (existing) TIPS accumulate inflation-adjustments to be paid only at maturity, their durations are higher vs nominal treasuries that don't change their cash flow patterns (coupon, par).

    TIPS funds behave differently in that they have to pay out the inflation-adjustments annually, whether earned or not, so that may require selling some TIPS holdings, or they can use inflows, if any.
  • (Macaulay) duration is the time weighted sum of cash flow present values normalized by dividing by the bond price.
    image
    https://www.fincash.com/l/basic/macaulay-duration

    What you were using was modified duration (or effective duration), i.e. sensitivity to interest rates:
    TIPS have higher durations than Treasuries of comparable maturities, so they are hit worse from rising rates.

    Modified duration is the derivative of present value (PV) with respect to rates (again, normalized by dividing by bond price, i.e. PV). That turns out to be Macaulay duration divided by (1+r) where r is the discount rate per coupon period.

    This is easy to see. Start with the PV formula:
    image
    After dividing by the bond price, differentiating with respect to i (rate) gives:

    {[(-1 x PMT1/(1+i)¹) + (-2 x PMT2 /(1+i)²) + ...)] / BondPrice} / (1 + i) =
    - ( timeWeightedCashFlowPVs / BondPrice ) / (1+i)
    - MacaulayDuration / (1 + i)

    Related to, but not the same thing as Macaulay duration.

    Still, that doesn't address your more significant assertion that TIPS' duration (whatever the form) is longer because cash isn't paid out until maturity. IOW, that TIPS are effectively zero coupon bonds.

    With a traditional CD, interest compounds at a fixed rate. So calculating APY and YTM is easy. In fact, all that really matters (except for tax purposes) is the final value of that CD. You could call it a zero since you don't get the cash flows until maturity.

    Still, there are interest payments; you can see it in the balance reported for your CD. The risk with fixed rate CDs (as with zero coupon bonds) is that interest rates may rise and you can't deposit those interest payments at the new higher rates.

    If the bank did allow you to draw the interest payments and redeposit them at higher rates, that CD would be more valuable to you. It's not that you're literally getting your hands on the cash, it's that you're able to get current (higher) market rates on the interest as it is credited.

    Same with TIPS. You don't get your hands on the inflation adjustments. But you see them in your balance (i.e. "principal amount"). And if inflation rates go up, that new balance benefits from the higher rates.

    In this regard, TIPS work even better than redepositing the CD interest or reinvesting bond coupon payments. With the CD or the fixed rate coupon bond, only the interest payments receive higher rates going forward. With the TIPS, the original principal (as well as the inflation "adjustments") receive the benefit of higher rates.

    With respect to inflation, TIPS are floating rate bonds, and as such have zero duration.

    I started with the statement: "The relationship between inflation adjusted (real) durations and nominal durations is somewhat complex." This may help (or further confuse):
    Nominal bonds are generally considered to have one duration (the sensitivity of the bond's price to a change in its nominal yield or interest rate), but inflation-indexed bonds, such as Treasury Inflation-Indexed Securities (formerly, Treasury Inflation-Protected Securities, TIPS), may be regarded as having two durations: Di, the sensitivity of the bond's price to a change in inflation, and Dr, the sensitivity of the bond's price to a change in real interest rates.

    For a nominal bond, whether a change in yield was caused by a change in inflation expectations or a change in the real interest rate does not matter; the effect on the bond's price is essentially the same either way. But for a TIPS bond, an increase in inflation does not affect the bond's price because the change in the cash flows in the numerator (of the equation for discounted cash flow analysis) is indexed to inflation and the discount rate in the denominator has also been increased by the same change in the expected inflation rate. Thus, the TIPS bond has an "inflation duration" of zero. A change in real interest rates, however, affects the price of a TIPS bond much as it does the price of a nominal bond, so a long-term TIPS bond has a long real-interest-rate duration—say, 15 years.
    https://www.tandfonline.com/doi/abs/10.2469/faj.v60.n5.2656

    That is why Vanguard moved to short term TIPS.
  • edited January 21
    I think that OP @larryB is now more puzzled about TIPS.

    BTW, the Fincash site you quote shows wrong denominator for Macaulay Duration - it should the the sum of the cash flows (not the bond price), so the weighting is indeed by the present values of cash flows, not by times. The result is duration in years (or whatever periods used) and weights are dimensionless fractions of PVs of cash flows. I have checked this with some finance books and also the Wiki,
    https://en.wikipedia.org/wiki/Bond_duration

    Interest rate sensitivity is a good and practical approximation of Macaulay Duration, and there isn't much difference between the two.

    Anyway, TIPS are rather complex in how they behave when held individually vs through funds (OEFs, ETFs). Most people holding those don't appreciate those complexity and are often surprised by results.
  • BTW, the site you quote shows wrong denominator for Macaulay Duration - it should the the sum of the [present values of] cash flows (not the bond price),

    In an efficient market, that is the price. If you prefer, we can call that the "correct" price rather than the "market" price. See, e.g. Investopedia, where the denominator is stated to be:

    "Current Bond Price = present value of cash flows"
    https://www.investopedia.com/terms/m/macaulayduration.asp

    [Wiki and Investopedia, IMHO not two of the highest quality references.]

    the weighting [of the amount of time to each cash flow] is indeed by the present values of cash flows
    Σ ti x PVi
    This is the same as the weighting of cash flow PVs by time to each flow.

    Certainly there are finance books that describe the expression as you've stated it. Just as other finance sources describe it the other way. FTSE Russell for example, says that "The Macaulay duration of a bond is the time weighted average of the remaining cashflows". (See Section 3.3 here.)

    image

    When I calculate the center of mass, I take each bag (cash flow PV) and weight it by its position (time). You may chose to calculate center of mass differently: by taking each position on the seesaw and weighting it by the size of the bag at that location.

    Either way, the result is the same.

    And yes, we (or at least I) have likely thoroughly confused the OP. In my defense, I chose to blame that on the complexity of the subject. :-)
  • Thanks for you explanations everyone. I appreciate all of your efforts. LB
  • edited January 24
    Rising bond yields, particularly on inflation-protected Treasurys, are viewed as close indicators of borrowing costs for businesses and consumers.

    Investors pay close attention to yields on TIPS because they offer an important gauge of financial conditions, indicating whether borrowing costs for businesses and consumers are rising or falling when stripping out the effects of expected inflation.

    “Often referred to as real yields, yields on TIPS have been deeply negative since the early days of the Covid-19 pandemic, helping to fuel outsize stock-market gains by pushing investors into riskier assets in search of better returns. Even today they remain below zero, meaning holders are guaranteed to lose money on an inflation-adjusted basis if they hold the bonds to maturity. Yet they have climbed even more this year than yields on ordinary Treasurys—a sign of higher borrowing costs for businesses, better forward-looking returns on bonds, and a return to more normal growth and inflation as the Federal Reserve starts tightening monetary policy …”



    Also (Same Article):

    “Donald Ellenberger, a senior fixed-income portfolio manager at Federated Hermes, is among those responsible for surging real yields. Starting in the early days of the Covid-19 pandemic, he was a major buyer of TIPS, steadily increasing them from 4% of his multisector bond portfolio in March 2020 to 7% by November of that year. Mr. Ellenberger’s concern at the time was that historic fiscal and monetary stimulus would lead to a surge in inflation—a fear that proved prescient as TIPS rallied and the consumer-price index soared… By the end of last year, though, the Fed had shifted course, promising to accelerate a wind-down of its bond-buying program and start raising interest rates … In response, Mr. Ellenberger and his team slashed their TIPS holdings from 7% to 1%.”

    (Excerpts from)
    “Tech Rout Fueled by Bond-Market Turn”
    By Sam Goldfarb
    The Wall Street Journal
    January 24, 2022

    In a separate article, the same issue of the WSJ noted that municipal bonds are also seeing outsized losses of late.
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