Why Do Bond Yields Rise with Inflation?

Instead, the prices of Treasury inflation-protected securities—government bonds that are adjusted to keep up with inflation—have declined this year, even as inflation has soared. These declines show how hard it has been to find a safe harbor from the fastest price-level rise in four decades, as reported by The Wall Street Journal.

Through Thursday, inflation-protected bonds tracked by ICE had lost 13.2% this year, including price changes and interest payments. The comparable loss for ICE’s index of regular Treasury bonds was 13.5%.

Holding a TIPS to maturity still ensures that inflation won’t reduce the purchasing power of your initial investment (more on this in a moment). But meanwhile, falling market prices are vexing investors who were counting on TIPS to cushion their portfolios.

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“These are some of the most pressing questions we get: Why the heck are my TIPS down when inflation is so high?” said Collin Martin, a fixed-income strategist at the Schwab Center for Financial Research.

Here is how TIPS work and why they haven’t been immune to the bond-market selloff this year.

Why is Inflation Bad For Bonds?

The government sells TIPS that mature in five, 10 or 30 years. Like Treasurys, TIPS pay interest twice a year—exempt from state and local taxes—at a rate locked in when the bond is issued.

The difference is that the face value of a TIPS adjusts to account for changes in the consumer-price index. That means interest payments rise with inflation, and so does the amount you get back when the bond matures.

Say you buy $1,000 of TIPS at face value maturing in 2027, with a 1% coupon. If the CPI didn’t rise, you would get $10 in coupon payments every year, or $5 every six months.

But if the CPI climbs by 8.3%—as it did in the 12 months through August—your coupon payment would rise by the same percentage, to $5.42. If inflation continued, the coupon would keep rising, and you would get back a higher principal amount in 2027. The extra principal would compensate you for all the CPI inflation over the years since you bought the bond.

What Happens When Bonds Yields Rise

Bonds yields rise to protect the economy from inflation, but a variety of factors—first and foremost interest rates—can affect bonds’ market prices. As a result of rising rates, prices of practically all bonds have fallen this year. That means that if you bought a new five-year TIPS in January and sold it today, you would have to accept a lower price.

Why have rates increased? The Federal Reserve has been raising them to fight inflation. Higher interest rates reduce the discounted current value of practically all investments—even those with inflation-adjusted coupon payments in the future.

If TIPS can lose market value during high inflation, what are they good for?

If withstanding inflation is your only goal, buying and holding a newly issued TIPS until it matures will get the job done.

The real yield on five-year TIPS is now about 1.8% a year—or about 9.3% total over five years. In effect, the Treasury is guaranteeing TIPS owners that their money will buy 9.3% more goods and services in 2027 than it can now, no matter what happens to inflation between now and then. (Federal taxes, to be sure, will eat some of those gains.)

Inflation protection makes TIPS very different from the way regular five-year Treasury notes work. If you buy one of those today, you will get nominal yields of about 4.2% a year over the next five years. But if inflation averages 5% a year between now and 2027, your money will buy less than it can today, not more.

What if I am invested in a fund that owns TIPS?

Some investors own TIPS through mutual funds or exchange-traded funds that focus on inflation-protected bonds. BlackRock, Vanguard, Schwab, Fidelity and other money managers all offer low-cost TIPS funds.

Financial advisers say that investing in funds can have some advantages over buying bonds directly. You don’t have to worry about reinvesting your money after bonds mature: The fund manager will handle that for you. Funds can also provide diversity, giving you exposure to TIPS that mature over a variety of time spans.

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For investors who value predictability, bond funds and ETFs have some drawbacks. Their price rises and falls with the prices of the bonds they own. Unlike individual bonds, they don’t have a maturity date, so there is no date on which you are guaranteed to get your principal investment back. If you need to cash out of your TIPS fund at a time like now, when bond prices have fallen, you might not get back as much as you originally invested.

On the other hand, because TIPS funds continually replace maturing bonds with new ones, fund investors are now gaining exposure to the higher yields that newly issued TIPS are offering. If you bought a TIPS earlier this year and simply held it, you wouldn’t enjoy benefits from the substantial rise in yields this year.

How do the pros use TIPS?

Schwab’s Mr. Martin said that for most individual investors, it is a bad idea to try to time the market by trading TIPS from day to day. But professional traders buy and sell TIPS when they think prices are high or low compared with regular Treasurys.

For example, a five-year Treasury note is now yielding about 2.4 percentage points more than a five-year TIPS (4.2% versus 1.8%). That figure is called the breakeven inflation rate. If inflation over the next five years averages that amount, buying and holding a Treasury will be exactly as good as buying and holding a TIPS.

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If you believe that inflation will actually average 3%, however, you would want to buy TIPS and sell Treasurys, since the breakeven inflation rate wouldn’t be enough to compensate you for the inflation that you expect. Instead, you would want the firm inflation protection that TIPS guarantee.

If other traders agree with you, rising demand for TIPS will push up their price. That will depress the yield, which moves inversely. That trading would help nudge the breakeven inflation rate closer to 3%—a move that would align market prices more closely with traders’ expectations. This dynamic is why many investors consider the breakeven inflation rate a market-based forecast of how much prices will rise.