Does the real Yield to Maturity (YTM) number quoted when an investor buys a TIPS still hold if there is deflation instead of inflation?
During the fourth quarter of 2008, when the stock market was in turmoil, the real yields on TIPS rose sharply. The real yield on 10-year TIPS broke the magic 3% number, a level that hadn't been reached for many years. The concern for deflation was raised as one possible explanation for the rising TIPS real yields.
The following online spreadsheet calculates the effect of deflation on TIPS:
Spreadsheet: TIPS During Deflation
I draw the following conclusions from the spreadsheet exercise:
1. As long as there is cumulative inflation between the date you purchase the bond and the date the bond matures, and you hold the bond to maturity, the actual real Yield to Maturity (YTM) will match the real YTM quoted at the time of the purchase.
It doesn't matter whether the bond was purchased at the initial offering or purchased a few years later on the secondary market.
If you buy bonds with a long maturity, say 10 years or more, it's hard to imagine there will be cumulative deflation for that long. Even Japan didn't have deflation for more than a few years. It doesn't matter if there is deflation in some years and inflation in some years, as long as there is net cumulative inflation between the purchase date and the maturity date, the above conclusion holds true.
If you don't believe we will have net deflation lasting a decade or longer, you can skip the rest of the conclusions because they become only academic exercises. Moreover, if we have deflation for that long, there are probably bigger problems to worry about than TIPS yields.
If you buy TIPS with short maturities, like a 5-year TIPS, it's possible to have deflation for 5 years.
2. If there is net cumulative deflation, there's a chance your real YTM can increase but it will never go lower than what you were quoted when you bought the bond.
The possible boost to real YTM comes from the par floor feature in all TIPS. United States Treasury will pay the deflation adjusted principal at maturity or the face value, whichever is higher.
If there is net cumulative deflation between the date the bond was originally issued and the date the bond matures, you will be paid more than the deflation adjusted principal value and therefore your real yield will be higher. Please note the relevant date is the original issuing date, not the date you purchased the bond if you bought on the secondary market.
It’s possible that even if there is only deflation after you bought the bond, the bond itself could still experience net inflation during its full lifespan due to inflation between the original issue date and your purchase date. In such case, you will only receive the quoted real YTM, without a increase.
In nominal terms, you can lose money. In real terms, you can't.
3. All else being equal, a TIPS bond with a lower index ratio at the time of the purchase can receive a higher boost to real YTM during deflation.
The index ratio reflects net inflation from the original issuing date to the date you buy the bond on the secondary market. A lower index ratio gives you a better chance for a bonus from deflation.
4. All else being equal, a TIPS bond with a lower coupon rate can receive a higher boost to real YTM during deflation, although the boost to real YTM is not as sensitive to the coupon rate as to the index ratio.
In short, when you buy a TIPS bond, be confident that your real YTM will never go lower than the quote even if there's deflation after you buy the bond.
If the real YTM and maturity are comparable between two bonds, first choose the bond with a lower index ratio, then choose the bond with a lower coupon rate, for a better chance for a bonus from deflation.
Finally, remember all these finer points are moot unless there is net cumulative deflation from the purchase date to the maturity date. If there is no net cumulative deflation, all bonds receive the quoted real YTM. One should never say "never" but it is very unlikely to have net cumulative deflation for many years.