As Oil Bubble Pops, Inflation Hedges Fizzle

TOUGH YEAR FOR TIPS

Investors in TIPS have been hurt by the recent slump in oil and commodity prices, as expectations of future inflation rates have dropped precipitously.

The break-even rate on five-year TIPS, a measure of the future inflation outlook, has collapsed by 40 basis points since August 7, when crude prices were trading at $76.98 a barrel, their second-highest ever close. Tuesday, oil prices fell to a seven-month low below $60, to $59.23.

But the more eye-popping movement has come in the break-even rate on TIPS maturing in January 2007, which has plunged to negative 1.68 percentage points from positive 2.27 percentage points in early August, said Michael Pond, interest-rate strategist at Barclays in New York.

"The bottom fell out of the TIPS product," said Barker.

As with a traditional bond, the semi-annual coupon rate on a TIPS issue is fixed. TIPS' principal is adjusted annually to reflect the erosion of its value from inflation; thus the bigger the rise in the Consumer Price Index, the bigger the increase in TIPS' principal.

"I think headline CPI drops and that is what you get paid on," said Barker, adding that he thinks TIPS are fairly valued. "I would consider adding them if they cheapen. Right now the break-evens are pricing in very weak CPI readings already, and should do better going into the end of the year."

Pond of Barclays said 10-year TIPS are "attractive" at a real yield of about 2.30 percent and is much less sensitive to price swings in oil and gasoline prices.