Remember, Fixed Income Investors: TIPS Are Still Bonds
While TIPS will provide a taxable accrual linked to changes in the All-Urban CPI, their ability to generate a return in excess of conventional Treasuries depends on sellers underpricing inflation insurance.
Classicists prefer the former translation, but they are a dull lot.
Perhaps fixed-income investors should hire someone to whisper in their ears, "Remember, TIPS are still bonds." This lesson seems to be forgotten willingly by most investors and deliberately by the financial services industry, which loves to stuff TIPS into all manner of what they dub "real return" vehicles. While TIPS will provide you with a taxable accrual linked to changes in the All-Urban CPI, not seasonally adjusted (CPI-U), their ability to generate a return in excess of conventional Treasuries depends on sellers underpricing inflation insurance. Let's update the chart used in that March article comparing the total return of the Vanguard Inflation-Protected Securities Fund in light of the intervening bond bull run and current retreat.
The comparative total returns since QE2 began on November 4, 2010 are -4.76% for the Vanguard fund, -6.32% for the Merrill Lynch index of 5-10 year Treasuries, and -7.66% for the ML index of 10-15 year Treasuries. Ten-year TIPS breakeven rates of inflation have jumped from 2.08% to 2.32% over the same period.
Now we have to ask whether the glass is half-full; did the lower loss on the TIPS portfolio in the face of rising inflation expectations satisfy their investors or were many of these same investors surprised at how quickly longer-term Treasury bonds can lose value? I will say, "Both," not only because it is the easy way out but because both alternatives have merit. However -- and I will hold myself to this -- I will go on record as saying further losses on TIPS portfolios in a combination of higher interest rates and realized changes in the CPI-U no greater than implied in the current breakeven rate will lead to a bevy of arbitration claims, lawsuits, and any two biblical plagues of your choosing.
We can map three-month-ahead relative performance of the Vanguard fund relative to 5-10 year Treasuries as a function of current breakeven rates and the shape of the yield curve as measured by the forward rate ratio between two and ten years (FRR2,10). This is the rate at which we can lock in borrowing for eight years starting two years from now, divided by the 10-year rate itself; the steeper the yield curve, the more the FRR2,10 exceeds 1.00. Blue bubbles represent points where the Treasury outperforms; the datum from three months ago is highlighted in red and the current environment is marked with a green bombsight.
The current configuration argues for conventional Treasuries to outperform TIPS through the first quarter of 2011. This is a relative, not an absolute, statement. Should interest rates jump, TIPS will lose on an absolute basis, and many investors will be absolutely surprised and absolutely unhappy with that outcome. Remember, they are still bonds and not loss-protection vehicles.
The information on this website solely reflects the analysis of or opinion about the performance of securities and financial markets by the writers whose articles appear on the site. The views expressed by the writers are not necessarily the views of Minyanville Media, Inc. or members of its management. Nothing contained on the website is intended to constitute a recommendation or advice addressed to an individual investor or category of investors to purchase, sell or hold any security, or to take any action with respect to the prospective movement of the securities markets or to solicit the purchase or sale of any security. Any investment decisions must be made by the reader either individually or in consultation with his or her investment professional. Minyanville writers and staff may trade or hold positions in securities that are discussed in articles appearing on the website. Writers of articles are required to disclose whether they have a position in any stock or fund discussed in an article, but are not permitted to disclose the size or direction of the position. Nothing on this website is intended to solicit business of any kind for a writer's business or fund. Minyanville management and staff as well as contributing writers will not respond to emails or other communications requesting investment advice.
Copyright 2011 Minyanville Media, Inc. All Rights Reserved.