BondsOnline Advisor

Time For TIPS?

by Stephen Taub

Is now a good time to take a fresh look at TIPS - Treasury Insured Protected Securities?

Afterall, in light of the Fed's fourth rate hike since June and some recent strong economic numbers, market pros are anticipating a more robust growth than they had anticipated just a month ago, which could create inflationary pressures. And that, fixed-income fans know so well, spells rising rates.

"The surprisingly strong 337,000 gain in non-farm payrolls reported on November 5 signal renewed strength in the labor market and dramatically increased the likelihood of a Fed tightening at the December 14 FOMC meeting," UBS told its clients in mid-November. "The greater possibility of a December rate move was reflected in the Fed Funds futures market, which is now pricing in an 80 percent probability of a 25 basis point rate increase, up from a 50 percent chance prior to the release of the payroll data."

"We continue to believe that the improvement we have seen in the economy following the soft patch it hit earlier this year, combined with the stimulus of a weaker dollar and lower oil prices, suggest that the bond market will eventually see higher yields and lower prices," says Bob Doll, President and Chief Investment Officer of Merrill Lynch Investment Managers.

As some investors anticipate this ramp-up, they are hedging their bets with TIPS. In fact, UBS points out that this sector modestly outperformed Treasurys in October, recording a 1.028 percent total return versus 0.789 percent for Treasurys.
Quick refresher course. The principal amount of TIPS is adjusted periodically to reflect the effects of inflation. A fixed rate of interest is paid twice each year on this adjusted principal amount. At maturity, if inflation has increased the value of the principal, the investor receives the higher value.

Currently, the investment bank maintains a neutral weighting on TIPS, noting, "breakeven inflation rates continue to hover around levels that appear only fair."

However, it cautions investors who are interested in this securities class to avoid going out too long. "There is little benefit to be achieved by going further out than 20-years on the TIPS curve, as the longer-dated securities do not offer sufficient yield pick-up beyond this point," UBS counsels.

One person who especially likes TIPS now is Bill Gross of Pimco fame.

His recommendation is borne in the belief that real interest rates in the United States will have to be kept low. "Too much debt in a finance-based economy precludes raising interest rates like we have in the past and while that keeps the patient/economy breathing, it leads to asset bubbles, potential inflation, and a declining currency over time," Gross elaborates.

How should an investor attempt to exploit this condition? Buy the assets that are being bubbled. In other words, invest in bonds that are protected against inflation, such as TIPS, he says.

"The low rates I speak to are really low real short-term rates," he explains to his clients in a recent missive. "If inflation continues upwards it would be logical for the Fed to raise nominal short rates just enough to contain prices, but not kill the economy."

He argues if we are facing a low real short-term interest rate future, TIPS investors can take advantage. "Since TIPS holders are protected 1-for-1 against increases in the CPI, the only thing they have to worry about is changes in real interest rates, the fundamental driver of TIPS prices," Gross explains.

What's more, if real short rates are capped then the risk of a decline in TIPS prices is reduced, and the potential for an increase may be enhanced, he adds.

Gross hypothesizes that if real short rates were capped for a period of some years at, say, 0.5 percent, and the Fed told the market that this was so, then all TIPS with maturities inside that timeframe should trade at close to the same yield, about 0.5 percent.

"Markets and life are never as simple as we pretend," he acknowledges. "Skim milk frequently masquerades as cream.

However, he says he and Pimco are confident that in this uncertain environment real short rates must stay low — perhaps as low as 0.5 percent. "The debt-laden finance-based U.S. economy is simply too fragile to tolerate what many consider to be more normal, real yields of 2 percent or so," he adds.

If so, assets that can lever off of an attractive low real rate and securities that are priced by real rates themselves, such as TIPS, offer opportunities as the marketplace adjusts to these new realities, he explains.

The upshot: One of PIMCO's new strategic bets based on this hypothesis is to own intermediate TIPS with real yields higher than 0.5 percent.

Gross, though, asserts that "lay investors" would be better off owning a TIPS mutual fund. "The funds they own, however, should be managed by professional investors willing to prioritize their own most certain ideas and to draw investment conclusions from them," he explains.

Of course, he won't mention that the Vanguard Inflation-Protected Securities funds are perhaps the most attractive. They are up 6.7 percent year-to-date, which is an astounding 3.5 percentage points better than the category. And, little surprise, its expense ratio is a puny 0.12 percent.
 

Stephen Taub is Contributing Editor to BondsOnline. Stephen has been covering financial markets for more than 20 years with Financial World magazine, Individual Investor.com, CFO.com, and others.