US Inflation Bonds Hit by Deflation, May Recover

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.

More From CNBC.com

• Stock Picker: Banks In For 'Huge' 2009 Rally
• Peter Schiff: Dollar Will 'Fall Like a Stone'
• Pros Say: A Few Investors 'Sniff' Capitulation

"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.

Copyright 2008 Reuters. Click for restrictions.