Why Are Inflation-Protected Bond Funds Losing Money? (2023)

Last week, inflation was reported at a 40-year high, posting a much stronger-than-expected rise. But inflation-protected bond funds racked up losses, extending declines posted since the start of the year. What gives?

In a nutshell, investors are getting a lesson in the dynamics of the Treasury Inflation-Protected Securities market. Just because inflation is high and rising doesn’t mean that a TIPS fund will be making money. It can easily be the opposite. Often what matters more is what is expected to happen with inflation in the months, quarters and years ahead.

“This is an area where it looks simple, and obvious: why not just buy them if inflation is going up?” says Eric Jacobson, fixed income strategist in Morningstar’s manager research group. “The answer is that the market had anticipated that would happen.”

Currently, while inflation readings have been getting hotter, investors are also expecting the Federal Reserve to take more aggressive action to put out the fire. “With TIPS selling off, the market isn’t reacting to the inflation news, it’s reacting to expectations of strength by the Fed,” says Jacobson.

This is playing out in negative returns on TIPS funds so far in 2022. The iShares TIPS Bond ETF (TIP) is down 4.5% so far this year, having returned 5.7% in 2021.

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Among actively managed TIPS funds, one of the largest, the American Funds Inflation Linked Bond Fund (BFIAX), is down 3.7% in 2022 after a 3.8% return last year.

There is still more to the story for investors to understand in order to make best use of TIPS in a portfolio, including understanding where TIPS are saying about the level of expected inflation, “real yields” and the exposure to changes in interest rates.

How Do TIPS Work?

Most traditional bonds offer a fixed periodic interest through their maturity at which point the owner – whether it’s an individual or mutual fund – are also paid back the face value of the security. To a large degree, yields on traditional bonds factor in expected inflation. The problem is that over time, inflation will still eat away at the value of that bond. That’s especially an issue for long term bonds.

TIPS solve for that problem by adjusting the amount due to investors based on changes in the consumer price index. This means that investors get paid more as inflation rises. If the CPI climbs 5%, the amount investors receive will also rise by 5%. (You can find a fuller explanation of TIPS and TIPS mutual funds here.)

TIPS have been around 25 years, but the current bout of inflation is the worst since the early 1980s. At the same time, inflation has moved higher in an extremely short period of time, fueled by the unusual circumstances of pandemic-driven supply chain problems coming out of a recession. That’s making for an environment unlike any seen by TIPS investors to date.

During 2021, TIPS were the best-performing major sector in the U.S. bond market. The Morningstar U.S. TIPS index rose 5.7% last year while the broad Morningstar U.S. Core Bond index lost 1.6%.

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Most of that rally in TIPS took place in the second half of 2021 as the recovery from the pandemic recession took hold and as the first hints of supply chain worries emerged. That led to a flood of investor money into TIPS and inflation-protected fund strategies more broadly.

The Fed Switches Gears

The turn in performance in early January for TIPS coincided with a shift by the Fed to take more aggressive action to raise interest rates, and pull back on the bond-buying purchases it had been making to pump money into the banking system during the recession. Since the start of the year, the U.S. TIPS index has lost 4.2%.

“I would put it on the shoulders of the reversal of policy from the Fed and other central banks,” says Steve Rodosky, a managing director and portfolio manager at PIMCO. “Expectations have moved from nothing or very little on the policy rate front in 2022 and 2023 to four-plus hikes for calendar 2022.”

One way to see the impact of changes in expectations around inflation and the Fed is to track the so-called breakeven rate. This rate--the difference between the 10-year nominal Treasury yield and the 10-year Treasury Inflation-Protected Securities yield--represents the market’s expectation of what inflation will be 10 years down the line.

Over the course of 2021, the 10-year breakeven rose from 2% to 2.7%, reflecting expectations for higher inflation. The 5-year breakeven registered 2% at the start of the year to a peak of 3.2% in mid-November. When the December and January inflation reports both came in hotter than expected, it showed that inflation is proving stickier than many economists predicted. On the surface that would have suggested continued upward pressure on inflation expectations.

But that hasn’t been the case. The 10-year breakeven has fallen back to 2.4% and the 5-year to 2.8%. While still up from where they were a year ago, those levels are heading back toward the Fed’s long-run inflation target of 2%.

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These readings show that “aside from front-loaded expectations of high inflation, the world expects a very tame inflation environment after that,” says Rodosky, who is a manager on the $12 billion Pimco Real Return Fund (PRRIX).

For TIPS, those declining expectations for future inflation are translating into expectations for lower future inflation adjustments and, as a result, lower prices.

Headwinds F
rom Rising Yields

Another headwind for some TIPS investors has been the rise in regular Treasury yields. The yield on the U.S. Treasury 2-year note jumped to nearly 1.4% from 0.7% at the start of the year, while the yield on the 10-year note hit 2% last week up from 1.5%. Both these changes are substantial moves in a short period of time. Despite the inflation protection, an overall rise in the level of interest rates will still feed through to the TIPS market, putting downward pressure on prices.

For this reason, Jacobson says that when bond fund managers and traders want to protect against--or bet on--an imminent rise in inflation, they will use short maturity TIPs that are less affected by changes in interest rates. For example, the TIPS bond maturing in July 2022 has risen in value so far this year even as longer-term TIPS have sold off, Jacobson says.

Another component has been an increase in what are known as “real yields.” Broadly, a real yield is a bond yield minus the inflation rate. Since the onset of the pandemic, real yields on TIPS have been negative. That means once investors account for the effects of inflation on their returns, even with the inflation protection offered by TIPS, investors would be essentially losing money on their investment.

Put another way, after inflation, “the premium you paid for that bond is so high, that you’re not going to make up enough income between now and the time the bond matures to make up for it,” says Jacobson.

What Quantitative Tightening Means for TIPS

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One reason that TIPS real yields have been negative is that the Fed has been buying huge amounts of U.S. Treasury bonds as part of its efforts to support the economy, an action known as quantitative easing, or QE.

“You had investors pouring into the asset class” seeking inflation protection, Rodosky says, “looking for the same bonds that the central bank was already buying.”

Recently, real yields have been rising. In addition to the changing expectations for inflation, the Fed’s stepping back from the market is removing a massive source of demand that had pushed yields down. Fed officials have begun discussing shrinking the amount of bonds it holds – the opposite of QE – a step known as quantitative tightening. “Since 2020, the marginal buyer of a lot of fixed income has been the Fed,” says Rodosky. That is leaving traditional market participants to set prices, and they are demanding higher yields.

What’s Next for TIPS?

The question for investors starts with the role TIPS play in a portfolio. If it’s simply part of a longer-term asset allocation, that as would be the case, dollar-cost averaging in over time means not having to worry about current valuations.

But for a more tactical approach, the question revolves around what TIPS are currently pricing in for future inflation compared to what an investor expects to happen. “You want to buy TIPS when the breakeven rate is lower than your inflation expectations,” says Jacobson.

Looking back to the breakeven rates, the TIPS market is priced for inflation to be 2.8% over the next five years.

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Pimco’s Rodosky sees an opportunity for investors to take out insurance against the possibility that inflation will be even stickier than it has been. “The market is priced for a pretty swift reversal of CPI levels down to where we are ending 2022 and going into 2023 in a 2.5ish range,” he says.

These expectations are based on the idea that once supply chain issues are resolved, inflation trends will go right back to pre-pandemic dynamics where globalization led wages and costs low and fiscal austerity in major economies kept a lid on economic growth, Rodosky says. Another outcome could be that the pandemic has altered the globalization story and households have considerably more pent-up demand from the last two years than is being factored in. Rodosky says if that’s the case, “the cost of insurance is quite low right now.”

Tom Lauricella does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’seditorial policies.


Can inflation-protected bonds lose money? ›

Treasury Inflation-Protected Securities can be a buffer against long-term inflation, but it's possible for TIPS price declines to outpace principal adjustment in the short term.

Why are inflation linked bonds falling? ›

Inflation on an investment portfolio means a loss of investment value, especially with fixed-income assets, such as bonds, CDs and treasury bills. Interest rates on fixed-income securities remain the same, so when inflation rises, bond prices fall due to the erosion of the purchasing power of coupon payments.

Why are bonds losing money right now? ›

One key relationship explains why bonds did so badly in 2022: Bond prices and interest rates move in opposite directions. “The Federal Reserve raised rates more than they have in 40 years. That caused massive losses inside of bonds,” says Robert Gilliland, managing director at Concenture Wealth Management.

Are inflation-protected bonds a good investment? ›

Inflation-index-linked bonds can help to hedge against inflation risk because they increase in value during inflationary periods. TIPS and many of their global inflation-linked counterparts do not offer very good protection during times of deflation.

What is the downside of tips? ›

Cons of Investing in TIPS:

TIPS typically pay lower interest rates than other securities, so they aren't the best choice for an investor with a fixed income. TIPS also comes with an interest rate risk. During deflation, the investor will either lose the interest earned or not earn anything.

Are inflation bonds risky? ›

They have no inflation risk, meaning your investment is protected against rising prices. This is in contrast to conventional bonds, which can lose value in real terms if inflation rates rise. Returns are not linked to the market.

What is the return on inflation-linked bonds? ›

Performance of inflation-linked bonds

Since 2010 Bloomberg's US 5-10-year inflation linked-bond index has returned 3.13% annually over that period, outperforming nominal bonds by 1.23% a year on average (see table).

Are inflation-linked bonds worth it? ›

Inflation-linked bonds do a great job at protecting against short-term inflation. They'll only outperform nominal bonds if the short-term inflation is unexpected, as any expected inflation is already reflected in the price difference between nominal and inflation-linked bonds.

Will bond funds recover in 2023? ›

Key Takeaways. Bond yields are likely to remain relatively high at least through the first half of 2023. Higher yields enable bonds to once again play their historical role as sources of reliable, low-risk income for investors who buy and hold them to maturity.

Will bonds go down if the market crashes? ›

When the bond market crashes, bond prices plummet quickly, just as stock prices fall dramatically during a stock market crash. Bond market crashes are often triggered by rising interest rates. Bonds are loans from investors to the bond issuer in exchange for interest earned.

What are the worst investments during inflation? ›

The worst investment to put money into, during periods of inflation, are long-term, fixed-rate interest-bearing investments. These can include any interest-bearing debt securities that pay fixed rates, but especially those with maturities of 10 years or longer.

Is it better to buy bonds when inflation is high or low? ›

Short-term bonds

And if rising inflation leads to higher interest rates, short-term bonds are more resilient whereas long-term bonds will suffer losses. For this reason, it's best to stick with short- to intermediate-term bonds and avoid anything long-term focused, suggests Lassus.

Are tips riskier than Treasuries? ›

TIPS Often Underperform Traditional Treasuries

With TIPS, an upward adjustment of face value also means that interest payments go up with inflation. TIPS are therefore perceived as safer, which lowers their expected returns because of the risk-return tradeoff.

What is the U.S. 5 year tips yield? ›

5 Year TIPS/Treasury Breakeven Rate is at 2.47%, compared to 2.54% the previous market day and 3.43% last year. This is higher than the long term average of 1.90%.

Are tips a good buy right now? ›

Many TIPS offer positive yields today, a marked improvement compared to the last two years. From March 2020 through the end of April 2022, most TIPS yields were negative. If you invest in a TIPS with a negative yield, you're essentially locking in an inflation-adjusted loss if held to maturity.

Does inflation hurt stocks or bonds more? ›

Stocks do significantly better than bonds during periods of high inflation, providing positive real returns in 11 of the 20 year periods (55 percent of the time). The average real gain for stocks during high inflation is 2.51 percent.

What is the downside of Ibond? ›

That said, I bonds do have some disadvantages, such as the fact that the bonds cannot be redeemed for one year after purchase and their early redemption penalties. If you redeem your I bond within five years of purchasing it, you'll lose the last three months of interest the bond earns.

Are bonds better than stocks during inflation? ›

Inflation-indexed bonds and Treasury Inflation-Protected Securities (TIPS), tend to increase their returns with inflationary pressures. Consumer staples stocks mostly do well because price increases are passed on to consumers.

What happens to Series I bonds when inflation goes down? ›

For example, the earnings rate announced on May 1 reflects an inflation rate from the previous October through March. Question: Will the value of a Series I bond decrease during periods of deflation, when the CPI-U declines? Answer: No. In periods of deflation, the bond's redemption value won't decline.

Do inflation-indexed bonds give real return? ›

One way to combat inflation is by investing in inflation-indexed bonds, also known as real return bonds. These bonds offer a guaranteed rate of return above inflation, protecting your purchasing power and ensuring your investment grows.

What happens to bonds when inflation rises? ›

As a result, bond prices tend to fall when inflation is increasing. One explanation is that most bonds make fixed interest, or coupon payments. Rising inflation erodes the purchasing power of a bond's future (fixed) coupon income, reducing the present value of its future fixed cash flows.

What is the safest investment right now? ›

Here are the best low-risk investments in March 2023:
  • High-yield savings accounts.
  • Series I savings bonds.
  • Short-term certificates of deposit.
  • Money market funds.
  • Treasury bills, notes, bonds and TIPS.
  • Corporate bonds.
  • Dividend-paying stocks.
  • Preferred stocks.
Mar 1, 2023

Should you sell bonds when interest rates rise? ›

The most significant sell signal in the bond market is when interest rates are poised to rise significantly. Because the value of bonds on the open market depends largely on the coupon rates of other bonds, an interest rate increase means that current bonds – your bonds – will likely lose value.

Should I buy bonds when interest rates are rising? ›

Including bonds in your investment mix makes sense even when interest rates may be rising. Bonds' interest component, a key aspect of total return, can help cushion price declines resulting from increasing interest rates.

How long will it take for the bond market to recover? ›

It has been a long time coming, but 2023 looks to be the year that bonds will be back in fashion with investors. After years of low yields followed by a brutal drop in prices during 2022, returns in the fixed income markets appear poised to rebound.

Are bonds doing worse than stocks? ›

Stocks offer the potential for higher returns than bonds but also come with higher risks. Bonds generally offer fairly reliable returns and are better suited for risk-averse investors.

Should I cash out my 401k before economic collapse? ›

Don't Panic and Withdraw Your Money Too Early

Surrendering to the fear and panic that a market crash elicits can cost you. Withdrawing money early from a 401(k) can result in hefty IRS tax penalties, which won't do you any favors in the long run.

Is real estate good to own During inflation? ›

As a byproduct, inflation can lead to higher home prices and creates an environment in the real estate market that usually sees higher mortgage rates and fewer buyers. The effect is overall positive for investors who already own assets in real estate or have a real estate IRA.

Where can I park cash during inflation? ›

As inflation has soared, Series I bonds, an inflation-protected and nearly risk-free asset, have also become a popular choice for short-term savings. I bonds are currently paying 6.89% annual interest on new purchases through April, down from the 9.62% yearly rate offered from May through October 2022.

Where should I invest to avoid inflation? ›

Here are some of the top ways to hedge against inflation:
  • Gold. Gold has often been considered a hedge against inflation. ...
  • Commodities. ...
  • A 60/40 Stock/Bond Portfolio. ...
  • Real Estate Investment Trusts (REITs) ...
  • The S&P 500. ...
  • Real Estate Income. ...
  • The Bloomberg Aggregate Bond Index. ...
  • Leveraged Loans.

Why are index linked gilts going down? ›

The capital value of the gilt/bond will fall because investors will want a bigger 'coupon' return to offset the increase in interest rates.

When inflation rises bond values can fall? ›

Inflation and Federal Reserve Policy

Since bond prices and yields move in opposite directions, rising yields mean falling prices. That means a lower value for your fixed-income investment.

Why do the market prices of bonds drop when interest rates rise? ›

Rising interest rates affect bond prices because they often raise yields. In turn, rising yields can trigger a short-term drop in the value of your existing bonds. That's because investors will want to buy the bonds that offer a higher yield.

What happens to gilts when interest rates fall? ›

Gilts also do better as central banks often respond to recessions by lowering interest rates to stimulate the economy. Gilt prices tend to have an inverse relationship to expectations of interest rates, so when interest rates go down, gilt prices go up.

Should you buy bonds when interest rates are high? ›

If your objective is to increase total return and "you have some flexibility in either how much you invest or when you can invest, it's better to buy bonds when interest rates are high and peaking." But for long-term bond fund investors, "rising interest rates can actually be a tailwind," Barrickman says.


1. Fidelity Inflation Protected Bond Index Fund | FIPDX
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2. Why I Am Not Buying I-Bonds [Are TIPS Better?]
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