Many investors have renewed their search for a hedge against future inflation as the U.S. Federal Reserve prepares to embark on another round of Quantitative Easing (QE2): approximately $900 billion of Treasury purchases through June 2011, with 3% of that in Treasury Inflation-Protected Securities (TIPS). What Are TIPS?TIPS, or Treasury Inflation-Protected Securities, are bonds issued by the U.S. Treasury. They have the unique property that their principal, or face value, moves one-for-one with inflation as manifested in the Consumer Price Index (not seasonally adjusted), while their interest rate remains fixed (though interest payments rise if principal rises or falls if principal decreases). Moreover, even if inflation turns negative (deflation) over the life of the bond, its face value at maturity cannot drop below par (initial face value, or 100%). TIPS are used by both individual and institutional investors to hedge against potential future inflation and lock in a guaranteed real, or after inflation, rate of return when held to maturity.One of their stated objectives in implementing this program is to raise inflation from its current uncomfortably low level (1.2% for headline Consumer Price Index (CPI) and 0.6% for core CPI year-over-year). Many investors fear that if inflation starts moving up from its current level, it may not neatly and precisely stop when it reaches the Fed's preferred 2.0% target. While TIPS are an obvious choice for an inflation hedge because of their explicit linkage to inflation some investors balk at the low yields currently on offer
Why Are Real Yields So Low
As shown in Figures 1 and 2, not only are absolute yield levels low, but they are also at multi-year lows. The two reasons for this are the low rate of growth of the U.S. economy and the Fed's commitment to not only keep the short rate pegged near zero, but also to actively purchase longer maturity Treasuries, including TIPS, thus pushing the entire term structure of rates lower. The Fed's actions are an attempt to generate growth and inflation by keeping real rates low, thus encouraging individuals and corporations to borrow, and hopefully invest in things like homes, equities, manufacturing plants, and hiring. In addition, the Fed hopes to turn savers into spenders by rendering the inflation-adjusted return on money parked in banks negative.
There are a number of ways investors can look to take advantage of the inflation-hedging properties of TIPS without locking in current low yields. We suggest ways to not only enhance yield potential, but also strategies to hedge against higher inflation that, in principle, have no exposure to real yields.
The Value of Active Management
We see a variety of ways that may generate additional returns in a TIPS portfolio without taking additional undue risk. For example, an investor does not have to purchase the entire TIPS universe or replicate the index entirely, but rather can target parts of the yield curve that still offer fundamental value. A useful exercise is to decompose real rates into "market implied" forward rates (rates for time periods that start in the future). Using the data in Fig.1 we can infer that currently the 5-year rate in five years is approximately 1.67% and the 10-year rate in 10 years is approximately 2.01%. Comparing these forward rates to the current rate on 5-year TIPS (-0.29%) indicates that most of the richness in real yields is coming from the shorter-term securities which have yields controlled by the Fed. The longer-term forwards are actually close to fair value in light of our expectations for GDP growth (shown in Figure 3). Hence, one can actively underweight shorter maturity TIPS relative to longer maturity TIPS in order to be invested in the fundamentally attractive sectors of the TIPS curve while avoiding richly priced sectors of the TIPS curve.
Another form of active management that can help generate excess returns is the choice of securities. All TIPS are not created equal. For example, age and seasoning determine the value of deflation protection embedded in a particular issue (this is because TIPS cannot pay less than their par, or original face value, at maturity even in the case of deflation over the life of the bond). The month of original issue and maturity go into determining how much inflation a particular issue is exposed to. (In any given year, inflation is not evenly distributed but displays a clear seasonal pattern "“ for example higher in the spring and summer months, lower in the fall and winter months). These and other factors go into determining the relative value between different TIPS issues. Often these are not correctly or accurately priced by the market. Avoiding the rich issues and concentrating on the cheap issues may be a way of enhancing portfolio yield relative to the index. In addition, one could venture overseas in search of higher real rates without taking much additional risk. One example would be Australia, where the fiscal deficit is currently 6%, compared to 10% in the U.S., and the debt-to-GDP ratio is 20%, compared to 95% in the U.S. However, in Australia, real rates on 10-year inflation-linked bonds are 2.53%, compared to just 0.69% on U.S. TIPS. Finally, while we expect the Fed to ensure that real yields stay low for an "extended period of time," active management would likely include underweighting duration in anticipation of an eventual rise in real yields, thus cushioning the portfolio against capital losses.
Inflation Hedge With Reduced Interest Rate Risk
(Note: Strategies discussed below may not be suitable for all investors.)
This approach essentially involves strategies that are variations of an "inflation breakeven trade" where one purchases TIPS and simultaneously sells a matched amount of regular nominal Treasuries. In this way, the investor only has exposure to the spread between the two rates (nominal and real rates, called the breakeven inflation rate) and, in principle, has no exposure to the direction of the rates. This is a self-funding hedge in that the Treasuries that you sell pay for the TIPS that you buy. This hedge should make money if inflation is greater than the breakeven inflation rate (currently 2.1% for 10 yrs) and loses if inflation is lower than this rate. One of the simplest ways of executing this strategy is in the fairly well-developed inflation swap market (see Figure 4) where one essentially outsources daily management of the position to a broker/dealer (at a cost). Another essentially unfunded approach is through inflation caps, which are options on inflation. Investors can pay a premium up front to purchase an option that pays off if inflation is higher than a "?strike' level over the life of the option. Because the inflation cap market is not as well developed or as liquid as inflation swaps, markups tend to be significant and substantially sized orders difficult to execute. However, the payouts expected from inflation cap strategies can be replicated via a portfolio of inflation swaps that are dynamically rebalanced periodically, with the intention of retaining the optionality, albeit typically at a much reduced expected cost, since the implied volatility in the inflation option market is typically much higher than the realized volatility in the inflation swap market.
Using Market Stability to Enhance Potential Returns
The TIPS market demonstrated low volatility recently especially when compared to regular nominal Treasury bonds "“ and we expect this to hold going forward at least as long as the Fed stays on hold. This is because TIPS prices respond to only one risk factor "“ the level of real rates. On the other hand, nominal government bond prices react to real rates and one additional factor "“ inflation expectations. Corporate bond prices respond to these two factors plus credit risk, and so on. So, we believe TIPS truly are a less risky asset. The volatility of TIPS in 2010 has been just 75% of similar maturity nominal U.S. Treasuries.
There are a number of ways to take advantage of the low volatility and high credit quality of TIPS to enhance potential returns while hedging against inflation. We enumerate a few below:
Overlay strategies. One approach is to use a derivatives-based overlay to combine the inflation protection of TIPS with the higher return potential from other asset classes. For example, combine a portfolio of TIPS with an overlay of a Credit Default Swap (CDX) index. This strategy combines the inflation-hedging property of TIPS with the higher yield potential of corporate bonds, essentially creating a synthetic portfolio of Corporate Inflation-Linked Securities (CIPS). For illustrative purposes, combining the 5-year Investment Grade CDX, which currently trades at a spread of 0.91%, with 5-year TIPS may result in a portfolio with a real yield of approximately +0.6% compared to â?'0.29% for just the TIPS currently. Similarly, combining the 5-year High Yield CDX, which has a spread of 4.80% as of 11/15/2010 with 5-year TIPS results in a synthetic 5-year real rate of approximately 4.5% (4.8% -0.29% = 4.5%).
Alternatively, one can move out of fixed income markets and combine TIPS collateral with higher volatility inflation hedges like commodities, or even equities. One such strategy, combining TIPS with commodities, is the basis of the $21 billion (as of 11/15/2010) in PIMCO's CommodityRealReturn Strategies. PIMCO, since the 1980s, has also been managing portfolios of S&P500 futures backed by a variety of fixed income collateral (Stocks Plus strategy). There is no reason one could not combine a portfolio of TIPS with an equity overlay as well. When running these derivative-based overlay strategies it is critical that the collateral be high quality and show low levels of volatility because it may be needed on short notice. In this strategy, TIPS may be appropriate.
Levered strategies. Investors can use leverage to enhance potential returns during periods of low and stable borrowing costs and steep yield curves (as we have now and may continue for the foreseeable future). Currently, it is possible to borrow against TIPS collateral at the general collateral, or GC, rate, which is currently near record lows at 0.30% annualized. Moreover, as mentioned earlier the interest rate volatility of TIPS today is about 75% of nominal bonds. So, for example, an investor with $100 million could borrow $50 million and buy $133 million worth of TIPS and still have only as much volatility as a $100 million nominal Treasury portfolio. The attractive volatility adjusted returns that TIPS could potentially generate make them attractive to hedge fund investors Pension funds and other longer-term investors may wish to take advantage of this as well.
"Effective" breakeven strategies. This is a combination of the levered strategy combined with the TIPS vs. Treasuries long/short strategy mentioned earlier. Essentially, the low volatility of TIPS mentioned before combined with less-than-perfect correlations with nominal U.S. Treasuries currently results in a beta or hedge ratio of approximately 50%. This means that in principle one needs to hedge the TIPS purchased with only half as many nominal U.S.Treasuries in order to build a portfolio that is potentially insensitive to the movement in interest rates. For example, a purchase of $100 million 10-year TIPS would be hedged with a sale of just $50 million 10-year nominal US Treasuries. In this approach $50 million of the TIPS would be funded by the sale of $50 million of nominal US Treasuries. The remaining $50 million of TIPS would be funded in the repo market. Given the current low level of borrowing (or repo) rates this "effective" breakeven strategy carries better (has a more attractive yield spread) than the simple breakeven strategy discussed earlier (consisting of $100 million TIPS bought vs. $100 million nominal Treasuries sold). This results in the "?"effective" portfolio having a lower breakeven inflation hurdle rate. As a matter of fact, given current valuations the 10-year breakeven inflation rate above which this portfolio makes money drops from 2.1% for the "simple" breakeven portfolio to just 0.85% for the enhanced breakeven portfolio (using a funding rate of 0.30%, 2.80% 10-year nominal rate and 0.70% 10-year real rate). As a practical matter, this is the way many sophisticated investors and Wall Street trading desks both view the potential returns and manage the risk of their TIPS positions. Once again there is no reason longer term, sophisticated investors wishing to hedge against higher inflation should not take advantage of this as well.
To conclude, there is a great deal of uncertainty about how much inflation the Fed's unprecedented balance sheet expansion could create. We believe that TIPS, when appropriately used are a good hedge against the likelihood of future inflation. We have shown ways TIPS could be used as the centerpiece of an inflation hedging strategy despite their current low real yield levels.
Past performance is not a guarantee or a reliable indicator of future results. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, and inflation risk. Inflation-linked bonds (ILBs) issued by a government are fixed-income securities whose principal value is periodically adjusted according to the rate of inflation; ILBs decline in value when real interest rates rise. Treasury Inflation-Protected Securities (TIPS) are ILBs issued by the U.S. Government. Certain U.S. Government securities are backed by the full faith of the government, obligations of U.S. Government agencies and authorities are supported by varying degrees but are generally not backed by the full faith of the U.S. Government; portfolios that invest in such securities are not guaranteed and will fluctuate in value. Commodities contain heightened risk including market, political, regulatory, and natural conditions, and may not be suitable for all investors. Derivatives may involve certain costs and risks such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested. Swaps are a type of derivative; while some swaps trade through a clearinghouse there is generally no central exchange or market for swap transactions and therefore they tend to be less liquid than exchange-traded instruments. Credit default swap (CDS) is an over-the-counter (OTC) agreement between two parties to transfer the credit exposure of fixed income securities; CDS is the most widely used credit derivative instrument.
Hypothetical examples are for illustrative purposes only. No representation is being made that any account, product, or strategy will or is likely to achieve profits, losses, or results similar to those shown. Hypothetical or simulated performance results have several inherent limitations. Unlike an actual performance record, simulated results do not represent actual performance and are generally prepared with the benefit of hindsight. There are frequently sharp differences between simulated performance results and the actual results subsequently achieved by any particular account, product, or strategy. In addition, since trades have not actually been executed, simulated results cannot account for the impact of certain market risks such as lack of liquidity. There are numerous other factors related to the markets in general or the implementation of any specific investment strategy, which cannot be fully accounted for in the preparation of simulated results and all of which can adversely affect actual results.
The views and strategies described may not be suitable for all investors. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, accounting, legal or tax advice. You should consult your tax or legal advisor regarding such matters. Statements concerning financial market trends are based on current market conditions, which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions and each investor should evaluate their ability to invest for a long-term especially during periods of downturn in the market.
The Consumer Price Index (CPI) is an unmanaged index representing the rate of inflation of the U.S. consumer prices as determined by the U.S. Department of Labor Statistics. There can be no guarantee that the CPI or other indexes will reflect the exact level of inflation at any given time. The Investment Grade CDX is an index comprised of 125 credit default swaps on individual investment grade credits. Tranches on this index are structured by order of loss from defaults among the underlying components of the index. The On-the-Run Investment Grade CDX index refers to the most recent series available at a point in time. The High Yield CDX is an index comprised of 100 credit default swaps on individual high yield credits. Tranches on this index are structured by order of loss from defaults among the underlying components of the index. It is not possible to invest directly in an unmanaged index.
This material contains the current opinions of the manager and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. Pacific Investment Management Company LLC, 840 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626. ©2010, PIMCO.
No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. Pacific Investment Management Company LLC, 840 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626. ©2010, PIMCO.
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