Deflation -- A Risk of Investing in TIPS
Another risk I associate with TIPS is the risk of deflation -- a general decline in prices (the opposite of inflation). If there were a protracted period of deflation, TIPS would potentially lose some value. However, while the principal will adjust for inflation, if there’s cumulative deflation over the life of a bond, any investor in TIPS will get back one hundred cents of the dollar from the Treasury. Some people refer to this as a deflation “put.”
Now, 10 years worth of cumulative deflation is relatively unprecedented in modern economic times, but it could happen. This brings into focus an issue having to do with differentiating one TIPS bond from another. TIPS that have been outstanding -- maybe, five or 10 years -- have accrued a fair amount inflation in their current value. And if there were to be protracted deflation theres TIPS could lose that accrued inflation down to the value of par, or the amount the bondholder is entitled to when the bond matures.
So TIPS bonds that have a lot of accrued inflation, at times, will underperform TIPS that are much newer and have almost no accrued inflation. This occurs because of investor concern that accrued inflation could be lost.
We saw this phenomenon at an extreme during the fourth quarter of 2008, when there was so much disruption in the economy and about deflation. And one of the themes of 2009 was essentially the reversal of the concern. As the market got more comfortable that the Fed’s monetary policy initiatives would be successful at forestalling deflation, those extreme valuation gaps, and the discounts that were being applied to bonds with a high level of accrued deflation, were largely removed.