I’ll Take the Over

Donald H. Plotsky
Head of Product Group

Executive Summary

  • Since their introduction in 1997, TIPS have been an important tool for investors who want to hedge against the risks of inflation. Like other inflation hedges today, TIPS are expensive, thereby limiting their potential effectiveness.
  • Buying TIPS outright today ensures a loss of purchasing power in the future, rendering them less effective as an inflation hedge.
  • Combining TIPS with a short position in fixed-rate UST can provide an effective hedge against increases in inflation expectations, accrual of current inflation and protection against increases in real interest rates.
  • The liquidity of these securities allows for flexibility in portfolio construction, thus allowing TIPS to be used as part of a dedicated inflation hedge or as an overlay strategy on the portfolio.

Those of you who have bet on football games understand the concept of the over/under bet. Essentially, the bookmakers (the market) estimate the total number of points likely to be scored in a game. Bettors (investors) can then bet the over if they believe the point total will be higher or the under if they believe the point total will be lower than the bookmaker’s estimate. Sounds easy enough…

The bond market establishes an over/under for inflation. This is simply the difference between the yield of a nominal Treasury (UST) and the real yield of an inflation protected security of the same maturity. This number is often referred to as the break-even inflation rate (BEI), which is the rate of inflation that is needed to cause an investment in Treasury Inflation-Protected Securities (TIPS) to be equal to or break even with an investment in a fixed-rate UST security. If an investor believes that inflation in the future will be higher than this number, then the investor would be better off owning TIPS (the over). If the investor believes that inflation will be lower than this number, then nominal UST would be the preferred investment vehicle (the under).

Many investors are expressing concern about the prospects for rising inflation as the Federal Reserve, the European Central Bank, the Bank of England and Bank of Japan have all embarked on various forms of quantitative easing intended to reignite economic growth and restore liquidity and confidence following the financial crisis. Excessive money creation can and generally does create inflation. While the argument continues as to whether or not monetary policy has been excessive or appropriate, many market participants are contemplating asset allocation decisions to avoid potential increases in interest rates and protect against the risk of higher inflation in the future.

The title of this paper may seem to suggest that we believe inflation will be higher in the future. To be clear, we are not convinced that inflation is imminent or that it will present a significant challenge in the near future. We do, however, believe that inflation hedging makes sense for those who would suffer if inflation were to increase meaningfully. This paper will focus on particular ways to use TIPS to hedge against both current and potential future inflation.

Approaches to Hedging Inflation

Common tools for inflation hedging include allocations to TIPS, gold, foreign currencies, timber, real estate, high income bonds, other commodity investments and equities. We believe that the best approach is to build a well diversified portfolio including all of the above.

While each of the aforementioned investments provides a measure of inflation protection, current valuations for many of these investments are a concern. The price of gold already reflects significant concerns about future inflation. Real yields on TIPS are negative out to twenty-year maturities. High-yield securities are offering their lowest yields ever and real estate has demonstrated that valuations can deviate significantly from inflation rates over the intermediate term.

So how can an investor obtain protection from rising inflation at a reasonable price? For the purposes of this paper, we will focus solely on TIPS and how they can be used in the current environment to provide inflation protection, despite the fact that most TIPS offer negative real yields and implied inflation is generally higher than prevailing rates of inflation. We will address a more diversified approach in a separate paper.

Step 1: Buy/Hold TIPS

If an investor is seeking to hedge against inflation, TIPS are typically a key ingredient. In the past, we have advocated purchasing TIPS as a total return opportunity. That is not the case today as TIPS, like many other fixed-income instruments, have become quite expensive. Still, we believe they can have significant value as a hedging tool. TIPS accrete principal at the actual rate of inflation (CPI-U) and pay a coupon that is reflective of the real yield. Traditionally, this real yield has been positive, but in the current environment real yields are largely negative.

  • While real yields are negative, coupons cannot go below zero, but prices can go well above par. The negative yield will be reflected in the amortization of the premium.

Before the crisis, 10-year TIPS provided a real yield of 1.50% or greater, thereby insuring that savings would grow with inflation plus a guaranteed premium. Today, 10-year TIPS have a yield of -0.75% (see Exhibit 1), indicating that the investor will see their investment increase in value by the rate of inflation and decrease in value by the amount of the real yield. Stated differently, in current dollar terms the investor will only have the equivalent of $99.25 one year hence. For a buy and hold investor, this negative real yield is essentially an agreement to forego purchasing power in exchange for certainty (not preservation) of principal in the future. If you are a saver, this is certainly not a great deal.

  • The yield on a fixed-rate 10-year Treasury is 1.78%. If we subtract the real yield of TIPS from the yield of the fixed-rate bond [Tsy yield – Real yield = BEI] (1.78% – (-0.75)) the result is +2.53%. All else being equal, this is the break-even inflation rate, or the rate of annual accretion that would need to occur on TIPS in order to generate the same yield as on the fixed-rate Treasury.

Exhibit 1
Real Yields
ill-take-the-over-2013-03
Source: Bloomberg.

Step 2: Sell Fixed-Rate US Treasuries

Another way to hedge against inflation risk is to take a short position in a fixed-rate UST security or a Treasury derivative. Like TIPS, a fixed-rate UST security has two components to its yield: 1) an expected inflation rate and 2) a real yield. The key difference is that with a fixed-rate UST security, the compensation for future inflation is determined at the time of purchase. Therefore, the sensitivity to a change in inflation expectations is equal to the sensitivity to a change in real yields. With TIPS, the principal value of the security will adjust with the actual rate of inflation, largely eliminating the sensitivity to a change in inflation expectations. Therefore, the price of TIPS will only change when there is a change in the level of real yields.

The price of a fixed-rate UST will decline when rates (or inflation expectations) increase, or increase when rates (or inflation expectations) decrease. If an investor sells a UST security short, then an increase in rates will result in a profit, and a decrease in rates will result in a loss. This relationship allows the investor to benefit from increases in interest rates associated with increased expectations for future inflation or an increase in real rates.

The short position has a cost. The investor must pay the periodic coupon, and in exchange, the investor receives the short-term rate (LIBOR) on the proceeds of the sale. This results in a negative yield for the position at current market levels.

Putting the Two Together

While each of the positions described above offers some form of protection against inflation, each has limitations. TIPS currently offer negative real yields, ensuring a loss of purchasing power, and a short position in UST requires negative cash flow.

While complexity can be your enemy when investing, in this case it may provide the greatest efficacy. Combining the strategies described above may provide a result that is more closely aligned with the investor’s objectives.

A combination of these two positions should be considered for investors who have been looking for a strategy that can benefit from a sudden and significant increase in inflation expectations and/or maintain purchasing power with increases in the actual rate of inflation.

Using This Position as an Overlay

The idea of constructing this position simply as a hedge would reduce the efficiency of the overall portfolio as the capital allocated would essentially earn a 0% nominal yield and a negative real yield. Given that we would be using UST securities on both sides of the position (long TIPS and short fixed-rate UST) the position is easily financed and enables it to be used as an overlay strategy on existing assets or on selected assets to produce a positive yield.

If the investor were to choose to finance the trade, in effect converting it into an overlay, the cash could be invested in another fixed-income asset that could provide a positive yield. The financing transaction is straightforward, pledging TIPS as collateral versus a loan. The cost will be based on LIBOR, and will actually hedge the financing risk inherent in the short position. As described previously, the short position requires the investor to pay the coupon. In exchange, the investor receives a LIBOR-based rate on the cash proceeds of the sale. To the extent that the investor receives a LIBOR-based rate on the short sale of UST and pays a LIBOR-based rate on the reverse repo of TIPS, there is no exposure to a change in LIBOR. The only difference will be the bid/offer spread between the borrowing rate on TIPS and the lending rate on the UST. By financing TIPS, the investor now has cash to invest in a portfolio of other securities.

Conclusion

Since their introduction in 1997, TIPS have been an important tool for investors who want to hedge against the risk of inflation. Like other inflation hedges today, TIPS are expensive, likely limiting their potential effectiveness. Buying TIPS outright today ensures a loss of purchasing power in the future, rendering them less effective as an inflation hedge. Combining TIPS with a short position in fixed-rate UST can provide an effective hedge against increases in inflation expectations, accrual of current inflation and protection against increases in real interest rates. The liquidity of these securities allows for flexibility in portfolio construction. This in turn allows TIPS to be used as part of a dedicated inflation hedge or as an overlay strategy on the portfolio.

Addendum: Duration and Yield Analysis

Owning TIPS provides a one-to-one exposure to changes in actual inflation regardless of maturity. If inflation goes up or down by 1%, the principal value of the position will increase or decrease, respectively, by 1%. We will define this as an inflation duration (dI) of one; a 1% change in value for a 1% change in the rate.

Exhibit 2
Duration Analysis of the Combined Position
ill-take-the-over-2013-03
Source: Western Asset

Selling a fixed-rate UST security of a similar maturity will effectively hedge the real rate duration (dR) of TIPS but preserve the sensitivity to a change in inflation expectations.

Exhibit 3
Yield Analysis of the Combined Position
ill-take-the-over-2013-03
Source: Western Asset

The net expected yield of this combined position is zero as, by definition, real yields plus expected inflation (what you receive by owning TIPS) equals the yield of a nominal UST of the same maturity.

Exhibit 4
Change in Value
ill-take-the-over-2013-03
Source: Western Asset.

While the combined position provides protection from an unexpected increase in inflation expectations as well as providing for the accrual of actual inflation, it offers a zero yield and potential losses if actual inflation rates accrue at a level below what had been expected.

We have now established the basic concept, owning TIPS and hedging the real yield duration (dR) by selling fixed-rate UST. This position has a zero expected yield and provides significant sensitivity to changes in inflation expectations (dE = -8.5), accrues value with changes in (CPI dI = 1) and has no exposure to changes in real yields (dR = 0).

Past results are not indicative of future investment results. Investments are not guaranteed and you may lose money. This publication is for informational purposes only and reflects the current opinions of Western Asset Management. Information contained herein is believed to be accurate, but cannot be guaranteed. Opinions represented are not intended as an offer or solicitation with respect to the purchase or sale of any security and are subject to change without notice. Statements in this material should not be considered investment advice. Employees and/or clients of Western Asset Management may have a position in the securities mentioned. This publication has been prepared without taking into account your objectives, financial situation or needs. Before acting on this information, you should consider its appropriateness having regard to your objectives, financial situation or needs. It is your responsibility to be aware of and observe the applicable laws and regulations of your country of residence.
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