Wednesday, January 10, 2007

Here's a tip, don't buy TIPS

In case you haven't noticed, TIPS had a horrible 2006. The Lehman Treasury index returned 3.08% while the TIPS index only returned 0.41%. I'm really not a fan of TIPS. Take a look at this graph:

The blue is Core CPI (year over year, that's how TIPS payout). The red is the contribution to total CPI from food and energy. Visually, its obvious that the red is much more volatile than the blue. In fact, the standard deviation of core CPI is 0.40 vs. 0.87 for food and energy, more than twice as volatile.

TIPS payout on total CPI, so if food and energy are contributing the majority of volatility in total CPI, then it is also the major contributor to TIPS returns. To me, TIPS are like owning a Treasury bond plus a tiny long position in commodities. So why not just buy a small piece of a commodity fund?

If you are really more concerned about principal stability, buy floating-rate bonds. A diversified portfolio of high quality floaters should yield in the 5.20% range right now. Floating-rates rise whenever the Fed hikes rates, so if you are worried about inflation, odds are the Fed is worried too. If you own the TIP, inflation actually has to happen in order for you to get paid. If you own a floater, you benefit from the Fed fighting against inflation, which is what they are likely to do.

The TIPS market was created by the Treasury because they believed that investors would pay up for inflation protection, even more than their actual inflation expectations. In other words, if you think CPI will be 3%, and the Treasury rate is 5%, some investors will buy the TIP at 1.75%, because completely eliminating inflation risk has value in and of itself. In particular, the Treasury had pension funds in mind, who often have CPI-linked liabilities which TIPS would help hedge.

Regular investors who buy TIPS are therefore paying a price as though they have a liability to hedge, when in fact, they do not. In my mind, this almost guarantees the investor is paying too much for inflation protection, and other options, such as floaters or commodities are a better idea.


Anonymous said...

Do you have any opinions on the NYSE listed preferred stocks that, for example pay LIBOR +.70% adjusted quarterly usually with a minimum of about 4%. The dividends are also qualified so you get the low tax rate.
I like your idea for the floating rate bonds but as an individual where can I find them?

Accrued Interest said...

Floating pfds aren't bad. +70 would only be a good spread on a very strong credit though. The only trouble with preferreds is that they have such a long maturity, so if the spread on the underlying credit widens, your dollar losses can be large. What's the name?

A lot of floating rate product has larger minimums, like municipal floaters usually have $100,000 mins, which is tough for most individuals. I know Nuveen and other closed-end fund companies sell floating rate bonds backed by a portfolio of municipal bonds, which are a good deal if you can find them.

Taxable corporate floaters are usually available in reasonable denominations. For a A-rated credit, and like 5-years to maturity, you should be something like +15 vs. LIBOR. If you have a broker, tell him you want to know the next time there is a new Merrill Lynch or Lehman Brothers or some such floating rate note (FRN) deal. That way you don't have to pay his ridiculous commissions. The big brokerage houses do FRN deals at least a couple times a year so between the 8 or 9 biggest firms, someone is likely to be doing a new deal soon.

Unknown said...

can't fight the tape as your facts are compelling ... also a fan, generally speaking, of common sense, and given Bernanke's Fed has been telling us repeatedly that inflation will subside, one way to see that we in the investment community are believing him is with TIPS doing exactly what you said -- UNDERperforming -- no? In Bernanke We Trust should be printed right there on TIPS certificates (do they even have such a thing)?

Can't help but ask the question after today's sloppy (at best) 10yr TIPS auction ... what caught my eye was the HUGE direct bid of 5.8% (directs include bids by non-primary dealers submitted for their own accounts) ... would appear someone, somewhere is willing to pay UP for said protection ... perhaps a hedge against stronger than anticipated econ growth that leads to inflation (and Bernanke being wrong?) ... any info on who this might have been would be extremely interesting ... would imagine it was NOT PIMCO given how overtly bullish on Treasuries they've been ... Speaking of which, with 2yrs bumping up against 200day moving avg (4.87) would think a fair amount of short-term traders are covering here ahead of ReSale Tales and investors like PIMCO may be adding to trades ... any thoughts there?

Accrued Interest said...

I was at a conference here in Baltimore maybe 6 months ago where some Western Asset Management honchos were speaking. For anyone who hasn't heard of them, WAM is probably #2 among U.S. bond managers by assets. At least top 5. Anyway, they were heavy on TIPS. So my tone in this post might have been a little haughty, there are obviously smart people who like TIPS. Just not me.

I suspect there is plenty of speculative trading in TIPS, so certainly hedge funds can get involved. Maybe some traders can get more leverage on TIPS than they can on oil? Dunno.

I think the natural bid for TIPS comes from pension funds.

Anonymous said...

TIPS have historically (admittedly short history) understated expected inflation as measured by the unbiased Michigan Household Survey and the slightly biased Survey of Professional Forecasters.

Right now, 10-Year TIPS are priced for higher inflation (2.27% on Jan. 11--dunno about now) than Bernanke's target, so you are to some extent betting against the Fed, but you're not betting that they'll fail completely--just that they won't quite make their target.

Accrued Interest said...

TIPS may work as a trade from time to time, but I don't like them as a core investment for all the reasons I stated in my post.

I suppose you are right when you say that TIPS can work if the Fed is a little wrong, but for what? 30bps? You can buy a Freddie Mac bond for 30 extra bps. Plus you are talking about a 10-year issue. Inflation has to remain higher for 10-years for your bet to work.

Anonymous said...

Well, I was just pointing out that though investors would in theory pay to avoid inflation--Campbell and Schiller wrote about the very thing 10 years ago--there is evidently something else that makes TIPS yield more than Treasury - expected inflation.

In "Expected Inflation and TIPS," Carlstrom and Fuerst found that thing to be liquidity (using the yield differential between on-the-run and off-the-run Treasuries versus their difference in liquidity as an explanatory factor for the yield on TIPS). TIPS earn a liquidity premium of 100 to 150 basis points minus an estimated 50 to 100 basis points for getting rid of inflation risk, giving about 50 basis points of differential between expected inflation and Treasury / TIPS differential.

Clearly, as last year, this does not always play itself out. Furthermore, liquidity is dynamic, so if the liquidity premium drops to near zero and you don't want to pay for inflation protection, then yes, it would be a pretty poor investment. But for people nearing retirement, TIPS can provide a guarantee of real income, which might lend itself to an investment, not just a trade.

Plus, really, in a fully diversified portfolio, it should be somewhere if it's not 100% correlated with another asset and is not grossly overpriced (and I think there's not much evidence of that).

Accrued Interest said...

Well, you certainly have solid background on this subject. I agree that for a select group of investors, the TIP has the benefit of matching a liability. So that's a great benefit.

That there is a liquidity premium for Treasuries vs. TIPS is a fact, not debatable. But that its 100bps is hard for me to swallow. Maybe at one time, but not now.

Long-term TIPS have a bid/ask around 5 ticks or so. That's not a guess, I'm looking at a live screen as I'm typing this. In yield, that's 1bps or less. The on-the-run 30-year has a bid/ask of 1 tick, which is around 0.25bps.

That bid/ask of 5 ticks is tighter than say, long-term large deal agencies, which only pay about 40bps more than Treasuries. Therefore liquidity premium for the Treasury vs. the agency can't be more than 40bps unless you argue that there is a negative credit risk premium!

So given that the bid/ask spread is tighter for TIPS vs. agencies, and the agency liquidity premium is something less than 40bps, then the liquidity premium for TIPS must be a good deal less than 40bps.

So it comes down to actual inflation coming in higher than expected inflation, which gets to the later part of my original post.

Anonymous said...

Alright. Well done on the liquidity front. So illiquidity cannot explain the higher yield on TIPS vs. nominal Treasuries given expected inflation from household and professional surveys. But that would make TIPS inefficiently priced (a bargain in this case).

I don't mean to belabor the point, but there's alpha (or not) in this discussion, so I think it's worth talking about.

Accrued Interest said...

Hey no problem. We should get to the bottom of this. I think I'll do another full post about this today.

Anonymous said...

A Lehman Brothers index comprising U.S. TIPS is up 11.7% since the start of 2007 and 10.4% in the past 12 months through Nov. 21, 2007. By contrast, the Standard & Poor's 500-stock index is nearly flat year-to-date and up 1.2% for the past 12 months through Nov. 21.

Accrued Interest, nice call....not!

Charles@Real Estate Philippines said...

You provide a wonderful and worthy blog. I am honored that I visited your post and get a lot of knowledge here. Thank you.