2011 Market Returns on TIPS
The TIPS market has performed surprisingly well in 2011, with steady gains throughout the year. Overall, TIPS returned 12.2%, better than the average return on comparable maturity Treasurys of 11.5%. TIPS returned 1.9% in the 2011 first quarter, 3.5% in the second quarter, 3.8% in the third quarter and 2.5% in the fourth quarter.
The chart below shows the TIPS yield curve at the end of 2010 and all of the quarters of 2011:
Source: Pricing obtained from Barron's and the Wall St. Journal; yields calculated by Lark Research, Inc.
TIPS yields fell rather sharply from an average of 0.71 basis points across all maturities at the end of the 2010 fourth quarter to -0.34 basis points at the end of the 2011 fourth quarter, a decline of 105 basis points. By comparison, yields on comparable maturity straight Treasurys declined from 2.31% on average to 1.19%. Thus, the breakeven spread narrowed slightly from 160 basis points to 153 basis points.
TIPS earned 1.9% in the first quarter, but Treasurys lost 0.2%. The difference in performance suggests that investors were increasingly concerned about inflation. Hence, they were willing to bid up TIPS, even as interest rates on straight Treasurys rose.
In the second quarter, both TIPS and straight Treasurys earned positive returns, with TIPS gaining 3.5% and Treasurys 2.7%. However, TIPS yields increased by 15 basis points to 0.14% on average; while straight Treasury yields fell by 31 basis points to 2.20% (from the first quarter). So the average breakeven spread narrowed by 46 basis points to 206 basis points. The rise in average TIPS yields despite the higher average total returns came about because prices of short-term TIPS fell by 1-2 points on average, which made their yields less negative. Thus, the yields on short-term TIPS increased, while yields on medium- and long-term TIPS declined.
In the third quarter, comparable maturity straight Treasurys outpaced TIPS, earnings a total return of 7.8%, compared with 3.8%. The gains in Treasurys were driven by longer maturity bonds, which earned an average 16.5% annualized total return. Yields on TIPS declined from 0.14% on average to -0.06%, while average Treasury yields fell from 2.20% to 1.32%. The breakeven spread narrowed further from 206 basis points to 138 basis points. The strong performance in straight Treasurys was driven by weakness and volatility in the equity markets.
In the fourth quarter, TIPS earned more than Treasurys with a total return of 2.5%, compared with 1.0%. Here again, the gains in both TIPS and Treasurys were driven by the longer maturities. Average yields on TIPS declined further from -0.06% to -0.34%, while Treasury yields eased from 1.32% to 1.19%. The breakeven spread increased from 138 basis points to 153 basis points. Although the stock market's performance improved, investors were still attracted to Treasurys and especially TIPS as a safe haven.
Source: U.S. Federal Reserve
The yield on five year TIPS ended 2011 at -0.73%, up off of its lows, but well below its yield of 0.25% at the beginning of the year.
Source: U.S. Federal Reserve
Meanwhile, 10-year TIPS yields declined from 1.07% at the beginning of the year to -0.05% at the end of the year.
TIPS performance was stronger than straight Treasurys throughout 2011. A summary of their average performance by maturity group for each quarter in 2011 is given in the tables below:
Source: Lark Research estimates calculated from pricing data obtained from the Wall St. Journal. Returns on TIPS and comparable maturity Treasurys were calculated from Dec. 31, 2010 to Mar. 31, 2011.
Total returns were modestly better in short- and medium-term TIPS in the 2011 first quarter. Yields on short-term TIPS were decidedly negative, indicating that investors craved their relative safety and protection from inflation. Breakeven spreads of 253 basis points on short-term TIPS implied that inflation expectations were modestly higher in the near-term than over the medium-term, where the spread was 236 basis points.
Source: Lark Research estimates calculated from pricing data obtained from the Wall St. Journal. Returns on TIPS and comparable maturity Treasurys were calculated from March 31, 2011 to June 30, 2011.
In the 2010 second quarter, total returns on TIPS and straight Treasurys were decidedly positive, with TIPS modestly outperforming straight Treasurys. The greatest gains were recorded on longer-maturity issues. Yields on TIPS rose on average, due to a significant decline in the negative short-term yields, as noted above.
Breakeven spreads dropped from 252 basis points in the first quarter to 205 basis points, due to a sharp drop in the breakeven spread for short-term maturities and smaller decline in medium-term maturities. Long-term TIPS spreads were flat between the 2011 first and second quarters. The decline in short-term breakeven spreads suggests that inflation expectations over these maturities have eased significantly.
Source: Lark Research estimates calculated from pricing data obtained from Barron's. Returns on TIPS and comparable maturity Treasurys were calculated from June 30, 2011 to Sept. 30, 2011.
In the third quarter, both TIPS and straight Treasurys continued to rally. TIPS yields on the very short end became modestly less negative (by 52 basis points), but those in the medium-term maturities became more negative (by 27 basis points). Yields on long-term TIPS declined 68 basis points to 0.77% during the quarter. At the same time, straight Treasury yields declined across the board by 23 basis points on the short-end to 141 basis points on the long-end. Breakeven spreads also declined across the board, but more so in the shorter maturities. Average returns on TIPS and Treasurys were both solid at 3.9% and 7.6%, respectively. Most of the gains were concentrated in the longer maturities.
Source: Lark Research estimates calculated from pricing data obtained from Barron's. Returns on TIPS and comparable maturity Treasurys were calculated from Sept. 30, 2011 to Dec. 30, 2011.
In the fourth quarter, both TIPS and straight Treasurys rallied again. TIPS yields for the short- and medium-term maturities became more negative (by 4 basis points and 38 basis points, respectively) and longer-term TIPS yields fell by 33 basis points to just 0.44%. At the same time, straight Treasury yields declined by 10 to 25 basis points. Breakeven spreads increased by 15 basis points from 138 bp to 153 bp. Average returns on TIPS and Treasurys were 2.5% and 1.0%, respectively. Most of the gains were again concentrated in the longer maturities.
(The breakeven spread is the difference between the yield on a straight Treasury security and the TIPS with the comparable maturity. This difference is viewed by many analysts as the implicit rate of inflation that is "built" into the straight Treasury yield. For example, the breakeven spread between a 10-year Treasury Note yielding 3.50% and a 10-year TIPS yielding 1.50% is 2.00%. All other things being equal, if you believe that inflation will average 2.00% over the 10-year period, then you should be indifferent between buying the Treasury Note or the TIPS. If you think that the average rate of inflation will be higher, you will earn more with the TIPS (because the annual inflation adjustment to principal will be higher). If inflation is less, the 10-year Treasury Note will give you a higher return.)
Chart 4 provides the spread between 10-year T-Notes and 10-year TIPS for 2011. It shows that the spread was relatively stable, rising slightly until mid-April, but then falling steadily until the end of September. In 2011, the 10-year breakeven spread declined from 231 basis points to 199 basis points. The historical average (2003-2010) for the 10-year breakeven spread is 216 basis points.
Source: Lark Research calculations from U.S. Federal Reserve data
A similar pattern was evident in the 5-year TIPS spread during 2011. For the year, the 5-year TIPS spread declined from 182 basis points to 163 basis points, well below its 2003-2010 average of 1.96%.
Source: Lark Research calculations from U.S. Federal Reserve data
Source: Morningstar via TD Ameritrade
Please note: A table for 2011 third quarter TIPS performance that I published in a previous version of this report which was carried on this web site from October 2, 2011 to January 7, 2012 had incorrect total return figures for the quarter. I mistakenly included total YTD returns (i.e. for the nine months ended Sept. 30, 2011) instead of the quarterly figures in this table. I apologize for the error and any inconvenience it may have caused.
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January 7, 2012
Stephen P. Percoco
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