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March 2007
Is the Role of TIPS in our Portfolio Models Misunderstood?
Recently we have been asked why we continue to maintain TIPS exposure in
our portfolios. We do this through our position in the PIMCO Real Return
bond fund. The fund primarily holds TIPS (83% of assets) but it also includes
modest allocations elsewhere to spice up the returns. Undoubtedly, much of
the questioning stems from the disappointing performance that TIPS turned
in during 2006. We believe, that in such situations, investors often misinterpret
the role of an asset class we hold - not just TIPS, but any under-performing
area.
Background
Before I begin on our reasoning though, let me provide a little background.
The U.S. Treasury has been issuing Treasury Inflation-Protected Securities
(TIPS) since 1997. TIPS provide investors with protection against inflation.
The principal value (face value) of TIPS increases as inflation increases
and decreases as inflation decreases (disinflation), as measured by the
Consumer Price Index.
When TIPS mature, investors are paid the inflation-adjusted principal or
the original principal, whichever is greater. Since a TIPS investor won’t
receive less than the original principal, the investor’s original principal
amount is protected against both inflation and disinflation. While TIPS pay
interest semiannually at a fixed interest rate, that rate is applied to the
adjusted principal; so, interest payments rise and fall with inflation. More
detailed information can be found at www.treasurydirect.gov
High-Quality Bonds
We use bonds to diversify and reduce portfolio volatility and TIPS are, first
and foremost, Treasury bonds, so they have essentially zero credit exposure
(risk). High-quality bonds such as Treasuries can be seen as a hedge against
economic and market weakness (witness the strong performance that bonds
turned in on February 27th, the day the Dow dropped 416 points). As we
saw then, when uncertainty (increased risk) suddenly occurs in a sector,
there is a “flight to quality,” as investors rush to get out
of the affected area and head for safer ground. As a result, longer-term,
high-quality bonds can provide more powerful diversification to equity
portfolios than cash.
Our primary reason for owning TIPS today is that we have a preference for
high-quality bonds in the current market environment. And our primary reason
for favoring high-quality is that credit spreads are tight. That is to say
that the spreads between the yields available on “risk-free” (from
a credit standpoint) Treasury bonds and corporate bonds (with varying degrees
of credit risk), are very narrow. In our opinion, the yield premiums that
investors receive are so low, that they are not worth the added credit risk
assumed. We are not saying that large scale defaults (or anything similar)
are on the horizon. Rather, we believe that the probability of credit spreads
widening — the yields on lower-quality bonds rising more than the yields
on higher-quality bonds and conversely the prices of low-quality debt falling
more — is sufficiently high to offset the slim yield advantage offered
by lower-quality bonds today.
The chart on the next page demonstrates just how narrow spreads to Treasuries
are now versus where they were just five years ago. We are using a 10-year
AA-rated corporate bond index in the example because we are talking about
investment-grade bonds (not high-yield) and the average credit rating in
the most widely used fixed-income benchmark, the Lehman Aggregate Bond Index,
is close to “AA.”
Inflation Protection
So TIPS provide the high-quality bond exposure we want, but why TIPS instead
of conventional Treasuries? As mentioned above, TIPS protect against inflation,
and, in our view, an insurance policy against inflation has merit. Many
investors might not necessarily think that current inflation levels (2.70%
year-over-year on core inflation) are troubling. But, investors with long
memories may recall a period in the late 1970s and early 1980s when double-digit
inflation was a big issue domestically. We are not suggesting that we are
retuning to that level of inflation, but the peace of mind that comes from
knowing you have some insulation from the damages of higher inflation on
your fixed income portfolio can go a long way.
In a February 28th interview, John Brynjolfsson, manager of PIMCO Real Return,
stated that he sees near term inflation being contained in the general area
of where it is today. However, longer-term he believes that changing demographics
will be one more item pushing inflation higher, and he is concerned about
how high it may potentially go.
Inflation Expectations
We may have internal debates on the future of interest rates, but we all
agree on the past. From our perspective, we see an economy that has had
significant excess liquidity, primarily from a Fed Funds rate that was
too low for too long. There are consequences of cheap money in the system,
and not all of them are good (anyone seen any articles lately on sub-prime
mortgage concerns?). We certainly acknowledge that rates have risen on
the short end, but from a historical perspective, rates are still low and
low interest rates (cheap money) are kindling for inflation. Chairman Bernanke’s
Fed has made it quite clear that they are in no hurry to lower interest
rates as they see a continued threat of inflation. In fact, the Bernanke
Fed has gained quite a bit of creditability from the markets from their
discipline in staying on message about inflation risks in spite of what
have been fairly benign inflation data in recent months.
Bernanke’s determination to stay-the-course in fighting inflation
may serve as a head wind for TIPS, as Bill Irving of Fidelity Inflation Protected
Bond recently suggested to me. However, if Bernanke is right about the risks,
inflation may indeed creep higher, which would favor TIPS over conventional
Treasuries. Inflationary pressures certainly remain throughout the economy
(near-full employment, wage growth, higher energy, medical and educational
costs). In fact, just last week we saw some less than benign inflation data
released by the Labor Department followed by an increase in the Fed’s
preferred inflation measure, the PCE (personal consumption expenditures)
deflator.
Any one item by itself may not be cause for concern. But collectively they
say to us that the perception that inflation isn’t a threat is just
plain wrong. When the most recent data was released, TIPS performed well.
In fact, after two full months of the new calendar year, the main TIPS index
is the best performer among all domestic fixed-income indices, including
non-investment grade indices.
There is legitimate debate within market and economic circles as to whether
or not we are about to enter a period of weaker economic activity. This is
likely to be influenced by the weakness in the housing market, which has
certainly seen its share of volatility. Credit spreads tend to widen- out
during periods of economic weakness, thus hurting the value of lower-quality
bonds.
Break-Even Spreads
This is how we see the TIPS world. As shown below, break-even spreads have
been both richer and cheaper than they are right now, but they represent
the low hanging fruit in the fixed-income world.
You would be hard pressed
to find someone who rationally believes that other sectors are cheap.
Current break-even spreads (the difference between the yields on the 10-year
Treasuries
less the yields on 10-year TIPS) are cheap. The current spread of 2.38%
means that an investor needs a minimum inflation rate of only 2.38% over
the next ten years to make it worth his while to invest in 10-year TIPS
over conventional (or nominal) 10-Year Treasury bonds. As I mentioned
above, the most recent inflation read is 2.70%. Summary
Lastly, while we make our own independent asset allocations and decisions,
we have some pretty good company in other professional investors who share
our thinking. Such value-based asset allocators as Rob Arnott and Jeremy
Grantham, have both recently commented that TIPS remain a favorite asset
class. Rob recently showed us a United Kingdom inflation-linked bond that
was part of a 50-year offering (it matures in 2055) that is trading with
a yield of — no this is not a typo — 0.75%! Sort of makes US
Treasury inflation-linked long bonds that trade with real yields of around
2.25% seem very attractive. Rob believes that there is plenty of room for
appreciation in U.S. TIPS. Finally, David Swensen, who is the Chief Investment
Officer at Yale University, suggests that long-term investors have an allocation
of 15% in TIPS.
We are not holding TIPS because we think they are going to outperform equities.
We are holding them because we want to have a high-quality, low-volatility
asset to diversify and reduce risk in your portfolio. If we are aiming for
quality in fixed-income, then U.S. Treasury debt is the highest in the world.
And if Treasuries are the answer, then why not Treasuries that also include
a cheap insurance policy to protect you against inflation?
Sincerely,
Chris Keith
Vice President
Fixed Income
Manager
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