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Thursday, August 12, 2010

If TIPs are such a bad investment in a deflationary environment why does that TIP keep going up ?

If tips are such a bad portfolio holding under deflation why have they done so well  recently when the coming deflation is the new "market consensus" ?

Earlier in the year with the conventional wisdom predicting inflation and higher interest rates many went 'all in" and positioned themselves aggressively to profit from higher interest rates. As the WSJ reports it didnt work out too well:
Betting against Treasury bonds was supposed to be the no-brainer strategy for 2010. Instead, shorting government debt has brought steep losses so far this year, due to surging bond prices as investors seek safety on worries that stocks could be hit by deflationary headwinds. The largest exchange-traded fund tracking the long end of the Treasury curve, the $3.3 billion iShares Barclays 20+ Year Treasury Bond Fund (trading symbol TLT), has rallied more than 10% year to date.
The largest exchange-traded fund tracking the long end of the Treasury curve has rallied more than 10% so far this year.
At the same time, a leveraged ETF designed to profit from falling Treasury prices, ProShares UltraShort 20+ Year Treasury (TBT), has lost more than a quarter of its value as yields have ticked steadily lower—bond prices and yields move in opposite directions.
Now that the conventional wisdom has done its 360 degree swing the crowd of advisors and advice givers is now positioning for the now "certain" deflation. Some of the advice risky, pushing portfolios into a position that will get burned badly if this "consensus forecast"(once again) proves icnorrect and (once again) the "no brainer" portfolio moves turn out(once gain) to be big losers. One interesting part of this poor portfolio advice is a simplistic evaluation of the role of tips in a portfolio anticipating deflation.

From the wsj:(my bolds my comments in blue)

How to Beat Deflation

Strategies to protect your portfolio from—and take advantage of—the dreaded 'D' word.

Bond-fund manager Jeffrey Gundlach—who thinks yields on the 10-year Treasury note could fall to 2%—has about 40% of the DoubleLine Total Return Bond Fund's assets in longer-term government debt, such as Ginnie Mae securities. If yields on 10-year Treasurys fall to 2% within a year, investors could reap total returns of 10% to 12% as the price of the securities jump, he says.
Zero-coupon Treasury bonds, known as strips, can provide the best protection, since the fixed rates are locked in and automatically reinvested at the fixed rate, says Troy Von Haefen, a financial adviser in Nashville, Tenn., who primarily uses Treasury strips as a deflation hedge and holds them to maturity.

The above positions will no doubt benefit greatly if long term interests rates fall further. Mr. Gundlach seems to be acticipating that the ten year bond yield will drop within a yea by almost  1/3 from its current 2.95% to 2% (!). It is also certainly true that longer term zero coupon bonds benefit most from lower rates(their duration = their maturity). It is also true that concentrating ones portfolio in this manner is a huge and risky bet on lower interest rates at a time when they are at their lowest levels in over a year.and two year bond yields near record lows. Perhaps another "no brainer" that won't work ?

Then there is the view expressed below on tips which seems also part of the conventional wisdom and is misguided:

Conversely, inflation-linked securities such as TIPS (Treasury inflation-protected securities) and I Bonds (inflation-linked savings bonds) could lose value in a period of sustained deflation. When the consumer price index turned negative in 2009, for example, rates on I Bonds temporarily dropped to 0%. Investors could see the value of their TIPS decline, since any negative change in the CPI would be applied to TIPS' principal, reducing the interest earned. (If investors buy TIPS at auction and hold the bonds until maturity, the Treasury pays the inflation-adjusted principal or the original principal, whichever is greater.)

Lots of confusion in the above paragraph. First off the "analysis" confuses price with yield

The price if a tips bond (and the tips etf) is reflective of the real yield on the tips in one's portfolio compared to the market real yield of tips.Price moves inversely to yield just like for regular bonds except for tips it is the real yield not the nominal yield that determines the price. When inflation expectations fall, real yields on the tips go down and the prices go up. The current real yield on the 10 year tip is around 1.1%. That explains the price appreciation in the tips etf in the chart  below. The fact that i bond yields (not the same as ibonds btw since ibonds are not a tradeable  instrument) went to 0% at one point is interesting but not particularly relevant. It also means that someone holding an inflation protected bond with a 1% real yield would reap a considerable capital gain in the unlikely event that tip yields hit zero.

Last month, Janet Briaud, a financial adviser in Bryan, Texas, sold her clients' holdings in TIPS, parked the proceeds in cash and has been putting as much as 20% of clients' money in long-term government bonds. "If markets come down over the next 18 months, we expect that investors will go to the safe haven of Treasury bonds," she says. 

Now here is a risky move that could turn out ugly with a little confusion thrown in as well. 
This advisor has gone "all in" with a massive and risky bet on long term interest rates falling when she already held a tips position that would likely give her considerable gains in the event of lower inflation with considerably less risk.

Take a look at the chart below It shows the long term treasury etf vs the tips etf. As can be seen the tip has held increased in value as inflation expectations have fallen and has been far less volatilie.
Long term treasury etf (tlt) vs TIP etf (TIP)


intermediate term treas eft (ite) v tip
.Perhaps even more interesting is this second chart which is the intermediate term treasury etf (ite) vs the  TIP etf.. Both etfs have approximately the same maturity. The two are extremely highly correlated (except for the bad data point in december 2009) and in fact the tip has benefitted more than the conventional bond from the recent rise in deflationary expectations.

Why would that be the case ? because as noted the price of tips moves inversely to moves in real yields, which like nominal yields move up and down in response to inflation expectations.If  inflation expectations godown prices of both nominal bonds and tips go up. 

Conversely of course if the conventional wisdom proves wrong and inflation expectations shift real and nominal yields will go up and the prices on tips and conventional bonds will go down.

But here's the really interesting argument for not dumping that tips position: The tips include an imbedded "option" on inflation. Should inflation go up the downside risk on the price of the inflation protected bond is reduced unlike that of conventional bonds.

Althought the tips position will gain from a market that anticipates deflation/low inflation it is a far less risky position than one that abandons tips for a long conventional 20 year treasury position. Why is that the case ?
should that "sure thing" not occur and we get inflation and not deflation it will certainly be the case that the rise in real rates will hurt the tips. But unlike the conventional bonds the tips have a built in hedge. The return on the tips consists of the coupon rate based on the locked in real yield+ an inflation adjustment the tips holder gets additional cash flow in the form of the inflation adjustment should inflation occur.

An increase in inflation expectations will hit the tips holder less than the conventional bond holder. The tips holder gains on the deflationary expectations, is hurt less than the conventional bond holder when inflationary expectations go up and gets an increase in his cash flow should actual actual inflation occur (unlike of course the holder of conventional bonds). In effect the tips position has a "long inflation put".due to its inflation insurance feature as we know long options positions are effectively insurance.

On the other hand that advisor who dumped her treasuries for long term treasuries will find her clients with greater losses since they get only the low coupon rate with no inflation adjustment. On a price and mark to market basis the losses on the conventional treasuries will be far greater. So as a trade/portfolio readjustment this advisor has definitely increased the risk of the portfolio by abandoning tips for long term treasuries She increased the risk if she is wrong and marginally increased the return if she is right.

From the point of view of a long term position the logic seems even weaker. With 10 year tips at a real yield of around 1.1% and then year treasury bonds at around 2.95% replacing tips with conventional treasuries means that inflation will have to remain below 1.85% over the life of the bond for the position to prove attractive. This is the implied inflation forecast in the treasury/tips yield curve. Historically an implied inflation forecast like this imbedded in the treasury/tips differential has been considered  a buy rather than a sell signal.for tips.

Whether from a long term  or a shorter term "tactical' portfolio positioning it seems that dumping tips in favor of long term treasuries might well be following the conventional wisdom into a risky "no brainer' trade that may prove quite constly. It certainly seems based on an incomplete understanding of tips.

As for the advisors comment about

safe haven of Treasury bonds,

with reference to tips and conventional treasuries of course that is a non issue the "safe haven" aspect refers to bond being backed by the full faith and credit of the us govt and of course both tips and convnetional treasury bonds are the same in this repspect.


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