Can someone explain what makes the TIP ETF go up and down?

[Nell-e]

The iShares TIPS Bond ETF seeks to track the investment results of Bloomberg Barclays U.S. Treasury Inflation Protected Securities (TIPS) Index (Series-L) which composed of inflation-protected U.S. Treasury bonds.

 

What would be the prevailing narrative as to why the [ticker:TIP] ETF went down from $113.94 on 11/20/2017, to $109.27 one year later?

 

I thought this ETF might be "a flight to safety" place to park your money.  Am I wrong?  Is the reason the ETF down because inflation fears were higher last year at this time?  i.e.  oil prices have fallen, FED will continue to raise rates

 

 

 

 

 

[TwoCitiesCapital]

Will be a combination of interest rates and inflation breakevens. They can move in unison or offset one another.

 

10-year rates are near 7-year highs. Virtually all fixed income increments purchased in the last 1-2 years will have a negative return due to the movements in interest rates.

 

 

[Nell-e]

Will be a combination of interest rates and inflation breakevens. They can move in unison or offset one another.

 

10-year rates are near 7-year highs. Virtually all fixed income increments purchased in the last 1-2 years will have a negative return due to the movements in interest rates.

 

 

 

Thanks for reply.  I don't think I'm getting it.  Let me ask another way.

 

Here's the Treasury Dept description for TIPS: https://www.treasurydirect.gov/indiv/products/prod_tips_glance.htm

 

I'm summarizing here:

TIPS, provide protection against inflation. The principal of a TIPS increases with inflation and decreases with deflation, as measured by the Consumer Price Index. TIPS pay interest twice a year, at a fixed rate. The rate is applied to the adjusted principal; so, like the principal, interest payments rise with inflation and fall with deflation.

 

However, when I check out the CPI trend, it's gone up over the last year.

 

https://www.bls.gov/regions/mid-atlantic/data/consumerpriceindexhistorical_us_table.htm

 

That makes me think that TIPS should have gone up in price over last year.  Is the correlation to 10 year treasuries an opportunity cost thing?  Meaning, even though the TIPS interest rate has gone up, the 10 year treasury is more attractive now so people are moving money from the TIPS to the 10 year treasury?  As a result, the price of TIPS have gone down, even though the adjusted principal/interest rate has gone up?

 

 

What am I missing?

 

Thanks!

 

 

 

[bizaro86]

TIPS are a series of payments.

 

Over the last year there has been inflation, so the nominal value of each payment has gone up.

 

Interest rates have gone up as well, so the appropriate discount rate for discounting the series of payments that make up the TIPS is higher.

 

The second factor outweighed the first, so the price is down. Basically, even though the nominal value of each payment went up the present value of each payment went down.

[Cigarbutt]

Another perspective:

 

Think of the yield as a real yield + inflation (CPI).

If you hold to maturity, you get inflation protection (floating rate) and minimum par value but, in the interim, you remain exposed to the interest rate risk on the fixed component.

I kept the following for reference:

http://www-stat.wharton.upenn.edu/~steele/Courses/434/434Context/TIPS/TipsGE2005.pdf

I like figure 5 on page 4 for conceptual reasons.

Take a look. The breakeven notion that TwoCitiesCapital refers to is well explained.

In the last year, real yields have risen and CPI is close to where it was.

Look also at FRED data: 10-Year Treasury Inflation-Indexed Security, Constant Maturity

[benhacker]

I think Bizaro and TCC have somewhat missed the key point.

 

#1 - as noted, the TIPs bonds pay a coupon which varies with inflation effectively.  This coupon has been positive and rising recently

 

#2 - it is not *rates* that effect the value of TIPs like other bonds... it is the "real" rate expectations (demands?) of buyers and sellers of TIPs.

 

Here is a table of 5, 7, 10, 15, 30 year TIPs *real* rates (aka, the rate of returns, after adjusting for the coupon *and* inflation that buyers are achieving when buying TIPs).  Note this REAL rate has risen while nominal rates have also risen this year... but that is not how it in fact must work, so you should not confuse the two.

 

https://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/TextView.aspx?data=realyieldYear&year=2018

 

To read the table, a 7yr TIPs buyer on Jan 2 of this year was expecting a real return of 0.42%.  Now that same buyer is only willing to pay up if they achieve a 1.04% rate of return (again, after inflation).

 

that is the equivalent of 0.6% / year in "rate rising" duration effect.  This is non-trivial for a 7 yr bond... roughly I would guess that would have moved a price of the 7 yr bond purchased Jan 2 down by 3.5%... so a buyer probably lost money this year.

 

Hope that is clear.  Note nominal and real yields do not have to move in tandem.

[Nell-e]

Thanks for all of the responses.  Each one contributed a little more to my understanding.  Ultimately, the question I wanted to answer is depicted by Figure 5 of Cigarbutt's PDF link which is "when does it make sense to buy a TIP?"

 

Follow up question:  Theoretically, if inflation comes in the near future because of tariffs/trade war and this prompts the Fed to not raise rates or even cut rates if economy slows, that would be good time to buy TIPS?

 

My guess is because in the above scenario there would be the combination of slow growth and even more inflation.  Is that a reasonable conclusion?

 

 

 

 

[Cigarbutt]

Thanks for all of the responses. 

...

Follow up question:  Theoretically, if inflation comes in the near future because of tariffs/trade war and this prompts the Fed to not raise rates or even cut rates if economy slows, that would be good time to buy TIPS?

 

My guess is because in the above scenario there would be the combination of slow growth and even more inflation.  Is that a reasonable conclusion?

Given those assumptions, your conclusion appears to be reasonable.

Historically, relative divergence has occurred but interest rates and inflation measures tend to move in unison.

Along the scenarios that you may want to consider and under the sub-group of what may prompt the Fed not to raise rates, you may want to assess other non-market forces which could be very vocal and the possibility that lower growth and not so great expectations about growth may cause the Fed to even consider lowering rates, perhaps big time, even if that's not part of the conventional discussions at this point.

 

BTW the table found in Figure 5 is a tool I have used often for many different problems, investing or otherwise. You combine two essential variables for a particular problem and the table helps you to define 4 groups of outcomes. I thought this was useful and helped compensate for limited analytical capacity and recently found out that Peter Thiel (in Zero to One) uses a similar approach for some problems.

 

[TwoCitiesCapital]

I think Bizaro and TCC have somewhat missed the key point.

 

#1 - as noted, the TIPs bonds pay a coupon which varies with inflation effectively.  This coupon has been positive and rising recently

 

#2 - it is not *rates* that effect the value of TIPs like other bonds... it is the "real" rate expectations (demands?) of buyers and sellers of TIPs.

 

Here is a table of 5, 7, 10, 15, 30 year TIPs *real* rates (aka, the rate of returns, after adjusting for the coupon *and* inflation that buyers are achieving when buying TIPs).  Note this REAL rate has risen while nominal rates have also risen this year... but that is not how it in fact must work, so you should not confuse the two.

 

https://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/TextView.aspx?data=realyieldYear&year=2018

 

To read the table, a 7yr TIPs buyer on Jan 2 of this year was expecting a real return of 0.42%.  Now that same buyer is only willing to pay up if they achieve a 1.04% rate of return (again, after inflation).

 

that is the equivalent of 0.6% / year in "rate rising" duration effect.  This is non-trivial for a 7 yr bond... roughly I would guess that would have moved a price of the 7 yr bond purchased Jan 2 down by 3.5%... so a buyer probably lost money this year.

 

Hope that is clear.  Note nominal and real yields do not have to move in tandem.

 

A real rate is simply a nominal rate plus less inflation - both of which are addressed in my post.

 

The point is nomindal rates can head higher even as inflation breakevens move lower - a case where TIPS would underperform Treasuries due to offsetting factors.

 

TIPS would outperform treasuries in an environment where expected inflation (i.e. breakevens) are widening regardless of what nominal rates do - but the question wasn't why have they outperormed or underperformed Treasuries. It was why are they negative.

 

 

They're negative because of the interest component - the rise in nominal rates has more than offset the expected increase in coupon income from rising inflation expectations.