The next great bull market

2016-02-26 4pm EDT  |  #TIPS #inflation protected securities #bonds

At the risk of boring everyone to death, I am writing about treasury inflation protected securities… again… And before you click to the next article, take a moment to have a look at this chart:

During the great financial asset chase of 2009-2015, money flowed into long dated yield assets. Securities with no yield, or whose yield was tied to inflation, were shunned. Until a couple of months ago, you were a pariah if you suggested this trend might change. Gold investors were tinfoil hat kooks who didn’t “understand” the uselessness of the protection it offered.

Now gold is one of the top performing assets classes with traders desperately scrambling to get some in.

The next great bull market

Treasury inflation protected securities (TIPS) are under owned and priced for perpetual Central Bank failure. Investors are convinced deflation is the bogeyman hiding in the closet.

These recent headlines say it all: “Japan back to flirting with deflation”,“Spectre of deflation looms over Germany”,“France falls back into deflation in February.”

If there is one thing I have learned from my years in the markets, when everyone expects something to happen, it almost never happens. The incessant chants from the investing community about how Central Banks are powerless to create inflation ensures betting on that outcome is a terrible risk reward.

But how do you go about taking the other side?

The problem with TIPS is they are not a simple bet on inflation. TIPS are made up of two portions which makes their movement through interest rate cycles confusing. There is a direct inflation linked component, but there is also fixed income portion. The fact that this fixed income component moves in the opposite direction of inflation is what makes profiting on TIPS so difficult.

Let’s walk through an example to illustrate the point. The 0.75% of 02/15/2045 TIP has a price of roughly $92 with a yield of 1.05%. That means the nominal yield you will receive on this bond is a little over 1 percent. But you will also receive the accrued compounded change in the CPI index at expiry. Today you don’t actually know how much this bond will end up paying out. If inflation ends up being 0%, you will simply get your 1.05%. If inflation averages 2%, then you will receive 3.05%.

Now let’s compare the TIP to an equivalent regular treasury bond. The 2.875% Treasury bond due 08/15/2045 has a price of almost $105 with a yield of 2.635%. This yield is not subject to any adjustments. The buyer of this bond knows he/she will receive a yield to maturity of 2.635% (actually it is not quite that easy as there is re-investment risk on the coupon, but let’s not nitpick).

The difference between the TIP yield (1.05%) and the guaranteed nominal yield (2.635%) is the amount of inflation the market is expecting over the life of the bond. The 1.585% represents the break even inflation rate.

What happens if inflation rears its ugly head?

Let’s say you are a big inflation bull. You load up the truck on this TIPS issue, sit back and wait to collect the dough. Then inflation comes roaring back. Next thing you know we have regular 4% CPI prints.

What do you think happens to interest rates in this scenario? Inflation is a bond investor’s worst enemy (after default), so bonds sell off hard. For the sake of argument let’s say the 30 year treasury spikes to a 5.50% yield.

The TIPS’ price adjusts in response to the increase in inflation, but if the real component of the interest rate (the amount investors demand over inflation) rises, then the TIPS will not rise enough to offset this loss.

In the advent of a return of inflation, bonds will be in a deep bear market. TIPS will be a better investment than regular bonds, but only on a relative basis.

To demonstrate this, have a look at the performance of these two issues over the past year.

During this period breakeven inflation levels have *plunged*, yet the TIP due in 2045 was actually up on the year. It gained 4%. The fact that regular bond gained 6% represents the collapsing of break even levels.

Remember the difference between the TIPS and the nominal treasury yield is the break even inflation level. The relative change in these two bonds is all that matters. They can both go up, and they can both go down, or they can go in opposite directions depending on the environment. Rising breakeven levels does not necessarily mean the price of your TIP will rise. It only means it will outperform the equivalent bond.

The way to play inflation…

Obviously if you have a mandate to be invested in fixed income and you believe inflation is coming, then shifting to a TIPS overweight is one way to protect yourself.

For speculators who don’t want fixed income exposure, but instead want a way to play the breakeven inflation rate, the way to go about it is to buy the TIP and short the regular Treasury.

That’s a pain in the butt. You need to match durations and spend way too much time monitoring the position.

That is why RINF is such a great product. The ProShares 30 Year TIPS/TSY spread ETF does all that work for us:

ProShares 30 Year TIPS/TSY Spread seeks investment results, before fees and expenses, that track the performance of the Credit Suisse 30-Year Inflation Breakeven Index.

Designed to provide exposure to 30-year breakeven inflation (a widely followed measure of inflation expectations) for those who think inflation will rise. The fund’s index is designed to be sensitive to changes in breakeven inflation. It is not designed to reflect CPI or other measures of realized inflation.

The key is to understand this is not a fixed income product. This isn’t some bond you stick away and hope to collect your coupon.

This is an ETF designed to follow the 30 year inflation break even index in perpetuity. It is the crack cocaine of TIPS products.

But if you want to bet on a rush to own some inflation protection securities, then this is the product for you. Before this is all through, I expect RINF to hit new highs. Eventually investors will be falling over themselves to own inflation protection. As usual they will have bought way too much of the wrong thing at the worse possible time. Buying it now when deflation is on everyone’s lips will ensure when they make the switch, we have plenty of inventory to sell to them…

Thanks for reading and have a great weekend,
Kevin Muir
the MacroTourist