By John Parry
NEW YORK, Nov 21 (Reuters) - Inflation-indexed bonds, for
more than a decade the government bond market's hands-down
outperformer, are taking their worst-ever beating as deflation
starts to take hold.
Falling oil prices and the credit crisis have swept away
inflation expectations, and the performance of Treasury
inflation-protected securities (TIPS) this year shows how the
swift reversal in inflation trends has pulled the carpet out
from under securities designed to protect investors from
run-away price increases.
If the United States is entering its own "lost decade" of
deflation akin to Japan's experience in the 1990s, as some
analysts fear, inflation-indexed securities' shellacking may
get worse.
"On an absolute basis there is a lot of danger because you
can get hit by deflation," warns Jay Mueller, senior portfolio
manager with Wells Capital Management in Milwaukee, Wisconsin.
Investors use TIPS to hedge against inflation and their par
value drops when inflation vanishes, as returns year-to-date
show.
According to the Barclays Capital U.S. TIPS Index (formerly
the Lehman U.S. Treasury TIPS Index), total returns are down
6.7 percent year-to-date through Thursday.
Another factor making investors nervous is that U.S.
inflation-protected government bonds have only been around
since 1997, unlike their counterparts in Britain, which was the
first major economy to issue inflation-linked bonds in 1981.
As an unseasoned asset, U.S. TIPS have not been previously
tested by anything like the record 1.0 percent monthly plunge
in U.S. consumer prices in October. And if prices continue to
fall, TIPS could be in for something worse than the erosion of
value that's already occurred.
So long as commodity prices are plunging, TIPS are likely
to suffer, analysts warn.
BETTING AGAINST SUSTAINED DEFLATION
Crude oil prices are now one third of July's record peaks
near $150 per barrel as the global economy slips into what many
economists fear will be a protracted and painful downturn.
Falling energy prices could create a period of deflation of
between three and six months, says Mueller, which would take a
bigger axe to TIPS valuations over that time.
But some analysts do not believe deflation will be a
long-term problem akin to Japan's decade-long period of price
erosion because of the Federal Reserve's intensive efforts to
revive institutions with massive amounts of central bank cash.
Investors willing to bet against sustained deflation may
well find attractive valuations in TIPS. After all, TIPS bulls
argue, they've delivered a negative 10 percent total return
since March, the worst run in their 11-year history, and prices
for gas, food, cars and clothing can't fall forever.
"I believe that in a two- to four-year time frame the
expansion of the Fed's balance sheet will produce more economic
activity and higher prices of real assets," said Tony
Crescenzi, chief bond market strategist at Miller, Tabak & Co
in New York.
The U.S. government is issuing unheard of amounts of debt,
with analysts expecting at least $1 trillion to hit the $4.9
trillion Treasury market in the next year to fund the Fed and
the government's sundry rescues of tottering banks, insurers
and manufacturers. There is a big inherent inflationary risk
over the medium term from pumping so much money into the
financial system, analysts warn.
"The monetary base that the Fed creates which normally
rises 3 to 5 percent per year is up over 100 percent over the
last 12 months. This has the potential to be extraordinarily
inflationary several years from now, if they don't undo that,"
said Bill Tedford, director of fixed-income strategy at
Stephens Capital Management in Little Rock, Arkansas.
So TIPS could prove a viable long-term prospect if massive
injections of government cash into banks ultimately reignite
inflationary pressures, these analysts reckon.
The spread of nominal 10-year U.S. Treasuries over
equivalent TIPS yields has narrowed to just 6 basis points on
Friday.
"For those who expect inflation to be higher than 0.06
percent over the next 10 years it is certainly a good time to
own these securities rather than conventional securities," said
Crescenzi.
But he cautioned that investors would need to hold these
assets to maturity and acknowledged that the chance the United
States will sink into a multi-year long spiral of falling
prices, although not Crescenzi's most likely scenario, does
carry risks.
(Editing by Andrea Ricci)
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