Time for another look at
Treasury Inflation-Protected Securities?
» Motivating Factors
"The shares of American companies which manufacture ice
tend to sell at a higher price in the summer, when their
profits are seasonably high, than in the winter, when no
one wants ice," wrote John Maynard Keynes in his 1936
economic manifesto, The General Theory. His example
explains institutional investors' attitudes toward Treasury
Inflation-Protected Securities, or TIPS, when they were
first issued in 1997: The existing markets were doing very
well, and no one needed inflation protection, so most
institutions ignored the opportunity to lock in a low,
certain rate of return.
A market crash and a few oil scares later, the US
inflation rate now seems to have nowhere to go but up. TIPS
are still a small marketoutstandings are just $260
billion, with a current market value of $318 billionand
there is a small universe of managers running them, with a
few wringing considerable value from this new market.
For the first two years of their existence, TIPS
performed poorly, relative to conventional "nominal" bonds,
due less to inflation conditions than to investors' scant
awareness of the new instruments (see "TIPS Sheet,"
below).
After the Great Unpleasantness of 2000, however,
sponsors' attention began to turn toward investments
offering less uncertainty and volatility, like TIPS. Seamus
Brown, vice president at JPMorgan Asset Management in
London, tells investors to ignore the historical return
data.
"Lately, TIPS have come back into vogue, and the excess
returns of the last three years may never be
replicated."
Of course, the purpose of TIPS is not to beat one market
or another; rather, it is to find returns that match a
plan's inflation--sensitive liabilities. "In TIPS, you have
an asset class that performs well when inflation rises, as
opposed to nominal bonds, which tend to perform poorly,"
observes William Lloyd, director of portfolio strategy at
Bridgewater Associates in Westport, Connecticut, a large
and innovative manager at the top of the shortlist of TIPS
track records. "With inflation-linked bonds, if inflation
is rising, the price of the security won't drop, and you'll
get a higher coupon as well."
The interest rates on nominal government bonds are made
up of three theo-retical components, explains Glenn Baker,
head of fixed income at Brown Brothers Harriman in New
York, and a partner of the firm. "There's a real interest
rate; a premium for the inflation that's expected over the
life of the bond; plus compensation for uncertainty about
what inflation will actually turn out to be." Because each
of these parts represents a set of market expectations,
they cannot be measured precisely.
"Compare that to an inflation-linked bond," Baker
continues. "You can see the real interest rate
directlyit's the coupon rate on the bond [fixed at the
time of issuance]." He adds, "There's no inflation
expectation component in the interest rate. Instead, the
principal of the bond is adjusted up and down, as inflation
rises and falls." For example, if a TIPS real-rate coupon
is 2%, and the rate of inflation in its first year is 4%,
the investor is paid 2% on an adjusted principal of 104.
TIPS quickly adjust themselves to changing
conditionsinflation rates are factored in based on monthly
consumer price index (CPI) reportsbut the financial
markets usually forecast inflation for pricing nominal
bonds pretty effectively and, over a long investment
period, the forecast errors probably would cancel out. So,
is there a real benefit to TIPS for long-term investors?
"For the long haul, 20 or 30 years," says Baker, "you would
get approximately the same return as on a nominal Treasury
of the same maturity, but TIPS should produce less
volatility in prices."
"We don't recommend inflation-linked bonds for the lower
volatility," says Brown, "because we think that, in the
future, they will have equal or higher volatility than
nominal securities in some circumstances. Instead, we like
them for the low correlation of returns with nominal
securities and other asset classes." The correlation
between the Lehman Aggregate and US TIPS indices was about
0.70 for the first seven years of the bonds' lives. That is
not a low correlation, concedes Lloyd, but, "during the
short life of TIPS, inflation has been stable, and you
would expect to see a high correlation when only real
yields have been driving both markets." If inflation were
to rise, however, and bounce around inside a wide range
(say 4% to 6%), so that inflation expectations rather than
real yields were the main influence, Lloyd asserts that
correlations between TIPS and other fixed-income assets
will fall, and provide the greater diversification needed.
"In view of the similar expected return between TIPS and
comparable nominal Treasurys, and the lower risk," Lloyd
adds, "we think inflation-linked bonds are a must-have
asset."
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Motivating Factors
The essential motivation for plans to own TIPS today,
however, is to facilitate asset-liability
managementkeeping asset values on track with growth in
liabilities. "Many pension plans, especially on the public
side, pay benefits that are linked to inflation," notes
John Brynjolfsson, managing director and real-return
portfolio manager at PIMCO. "Even plans that pay fixed
benefits have an exposure to inflationthrough their active
participants, whose benefits are determined by their last
few years of salary."
"TIPS can hedge the CPI component of wage inflation, but
not the rest of it," cautions Barton Waring, managing
director at Barclays Global Investors and head of the
firm's client advisory group. The 30% or so difference
between wage inflation and the CPI is a complex function of
productivity, GDP growth, and other factors, that don't
lend themselves to hedging, Waring says. "However, that 70%
is a pretty good step in the right direction."
More impartial observers of the TIPS marketinvestment
consultants, rather than managersare less rhapsodic. "TIPS
can be useful in the arsenal of an actively managed
portfolio, such as a core plus mandate, where a manager has
a point of view on inflation, and can capitalize on it
through the TIPS market," contends Brian Birnbaum,
principal at Ennis Knupp + Associates in Chicago. "However,
if you believe that the market as a whole makes a good
forecast of long-term inflation," he adds, "then there
probably is no benefit to a strategic allocation to
TIPS"because more suitable inflation hedges are available,
and likely already in a plan's portfolio.
For the traditional institutional investorwith a 15- to
30-year time horizon, and a significant allocation to
equitiesBirnbaum says it is not clear that explicit
protection against inflation through TIPS is necessary, as
equities themselves are an effective inflation tracker.
Since 1970, he reports, US equities have averaged an annual
return of 6.2% above inflation. For short periods, however,
equities would not be a reliable hedge, while returns on
TIPS would match the CPI irrespective of what happens in
the surrounding markets.
The bottom line on TIPS for Bill Dewalt, director of
research for Watson Wyatt in Atlanta, is not the hedge, but
the yield on TIPS. He notes: "In the end, they earn just a
Treasury return, and that makes them less attractive for a
strategic allocation." That low return, however, includes
an implicit deduction for the cost of the inflation hedge,
and will be attractive to sponsors that desire that sort of
insurance.
"Most pension plans using TIPS have just dabbled in
them, with policy positions of 2.5% or 5% of their
portfolios," notes Brynjolfsson. "Due to their low risk and
inflation hedging capability, optimizers suggest that plans
might hold 25% or 50% of their assets in inflation-linked
bonds."
Brynjolfsson posits that inflation-linked bonds are the
ultimate riskless asset: "Cash can provide a positive or
negative real return, which can become substantially
positive or negative over 20 years, while TIPS pay a fixed
real return when held to maturity. That's even more
riskless than cash."
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