February 13, 2013 7:13 pm

US inflation-linked bonds lose lustre

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Enthusiasm for US inflation-linked bonds is souring as losses increase and investors pull growing sums of money from the sector.

An index of Treasury Inflation Protected Securities, dubbed Tips, has recorded a total return of minus 1 per cent in 2013, outpacing the 0.81 per cent slide seen for the cash or nominal Treasury index, according to Barclays.

In turn, there has been a large outflow since the start of January from the Tips sector, with investors pulling $821.54m from the iShares Barclays Tips exchange-traded fund, according to Index Universe. That eclipses the outflow of $818.55m from the ETF for the final quarter of 2012. Mutual funds that hold inflation-protected securities recorded their largest weekly outflow this month since July of 2012, according to EPFR.

The shakeout in Tips comes after several years of strong performance that leaves them looking very rich, and therefore vulnerable given the current lack of inflationary pressure and a backdrop of rising Treasury yields.

“The iShares ETF outflow is probably a good leading indicator,” said James Evans, portfolio manager at Brown Brothers Harriman. “This could be a year of negative total returns for bond funds.”

The strong performance of Tips in recent years has pulled their real or inflation-protected yield – which moves inversely to price – below zero, entering negative territory. Much of the capital appreciation for Tips has been a function of bond prices rising as their yield has turned negative.

“With real yields at negative levels, we are certainly not at the point where investors can buy Tips that offer good value,” said Scott Minerd, chief investment officer at Guggenheim Partners. “The bull case for Tips is that inflation concerns cause Tips to become even more over valued, which is not a core investment strategy.”

Since January, the real yield for 10-year Tips has risen about 20 basis points, roughly tracking the 10-year Treasury yield, which has jumped from 1.76 per cent to 2.02 per cent.

“Real yields can rise and so can nominal bond yields, without inflation moving higher,” said Mr Evans.

Bill Irving, portfolio manager at Fidelity Investments, said: “A lot of investors don’t understand the price risk they face from real yields. Inflation can rise, but you can still lose money on this investment from higher real yields.”

Tips have outperformed Treasury bonds since the start of 2009, with their gain of 7 per cent last year handily beating the 2 per cent total return of the Barclays Treasury index.

Michael Pond, head of global inflation-linked research at Barclays, said Tips might struggle in 2013 after several strong years of performance. He added: “If bond yields go up, Tips can record a negative return. Tips funds may rally as inflation rises, but ultimately lose out if real rates rise amid a wider bond market sell-off.”

“Given how well Tips performed last year, I don’t think they will do as well this year.”

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