TIPS and zero/negative interest rates


D

David S Meyers CFP

I've been thinking a lot lately about my positions in TIPs,
and their place in a portfolio, and, of course, their current
pricing level.

They are really purely an inflation hedge. At this point,
with zero/negative interest rates, they are nothing at all
more than a perfect hedge on CPI-U. They generate no income.

So when constructing a portfolio and including fixed-income
exposure, there are generally two different reasons to include
it. In a total-return view, they are there only partially
for income/yield but very much more are there to provide
asset-class diversification to provide uncorrelated returns
against equity exposure. In that total-return context, the
actual returns of the fixed income, and especially the cash-flow
that it generates are less important than how they behave when
stocks move one way or the other. This is generally a stronger
argument for US Treasuries, even though they generally have
lower yields than any other fixed income, they also have a lower
correlation with equities and have had, especially through
the last couple of disaster markets, great returns as yields
have dropped through the floor.

The other place for fixed income is in a cash-flow/income
oriented portfolio, where the bonds are there to generate a
paycheck for the investor and the stocks are there to provide
growth (and a smaller paycheck through dividends), especially
over the longer-run and to overcome inflation. In this
context, the correlations and even the potential for capital
gains (ie. dropping interest rates) are less important than
the dividends paid out.

So now where do TIPs fall in this? Clearly not in the latter
income-oriented portfolio, since right now they don't generate
any income at all.

But I'm also thinking that given the absurdly low yields of
both TIPs and other Treasury bonds, maybe there's no place
for either of them in either income or total-return portfolios.
In essense, they don't fit into income due to the low to
non-existent yields. But they may well not fit into a total
return portfolio either given that the interest rates are at
historic lows and seem unlikely to go down any more - so there
really seems almost no potential at all for capital gains
either - meaning that even if stocks drop again, I find it
hard to believe that TIPs or Treasuries can perform the
function that they are supposed to in a total return portfolio -
they cannot zig *up* any more whether stocks go up or down.
So even though I don't generally subscribe to market timing,
can one justify keeping TIPs or any Treasuries in a portfolio
right now?

Thoughts?
 
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D

David S Meyers CFP

Tips and especially Tbills (TLT) have been showing modest cap gains
according to
http://chart.finance.yahoo.com/z?s=TLT&t=2y&q=l&l=off&z=l&c=LQD,PFD,PFF,TIP&a=v&p=s
My concern is that we're likely at a place in the yield structure
where future capital gains in treasuries and TIPs are just astoundingly
unlikely. The TIPs, at least, will continue to rise along with the
CPI-U, which is a huge plus over nominal treasuries, but if/when rates
do go back up, there are going to be cap-losses. At this point, the
inflation hedge is probably a stronger influence - I don't see rates
moving upwards a lot in the next year or two, given the Fed's strong
public stance of keeping rates down. This, by the way, leads me to
think more highly of TIPs (over nominal Treasuries at least).

The question of what they are there in the porfolio for is still an
important one. As I said, TIPs cannot provide useful current income
any more, but in a total return context, they are a pure - and
short-term - inflation hedge. In the longer run, equities are a
better inflation hedge, but short-run inflation whacks equities very
hard. So in that context, TIPs may well still have a place in the
portfolio to moderate overall portfolio volatility.

We are in a different world now than the one in which Zvi Bodie
told folks that for "worry free" retirements, they needed portfolios
built predominatly out of TIPs. He wrote that in '02 and '03, when
TIPs real yields were like 3%. A guaranteed 3% *above* inflation
is a spectacularly good arrangement. It's also no longer available.
But in today's crunch, what I do is settle for something partially
correlated with at least some return. It raises risk and volatility,
which I will deal with by waiting out lengthy cycles. A modest way to
deal with this is corp bonds (LQD) which bumps up yield a bit over
I do like corporate bonds, at least relative to treasuries. Vanguard's
got a short-term corporate index ETF, VCSH (I think), which us currently
yielding something over 2%. And I've been using LQD for a while in
combination with AGG or BND, in order to overweight corporates in the
fixed income allocation (well, to underweight treasuries).
step is preferreds (PFF) which gives you double the interest. The
financial preferreds (PFD) additionally has been giving great cap
If I'm going to go that far down the credit quality spectrum, I'd
rather just get some equity exposure directly. Financial preferreds
are almost as volatile as financial equities, but with more limited
upside. In more normal times, preferreds may have behaved more
like bonds - perhaps more like junk bonds - but they've always had
more of the risk chacteristics (volatility) of equities. They
don't really balance out an equity allocation very well, since they
are so highly correlated with equities. I'd rather just keep the
asset classes more cleanly separated - equities on one side and
fixed income on the other. Nevertheless, those two ETFs are well
worth keeping an eye on.

Junk bonds may still be a good satellite holding in the fixed-income
sleeve, especially to help increase cash-flow yields, but they really
can't safely be the bulk of it. JNK (with a 0.40 expense ratio) may
be a good way to go here, but like the preferreds, it's more like equity.
If it can be bought at a discount to NAV (the discount/premium itself
can be quite volatile), something like NHS (a junk-bond closed-end fund)
may be a good way in, but it is a leveraged junk-bond play, generating
a huge current payout yield, but with very severe risk.
A better way in, though it's both expensive (high expense ratio) and
still similarly risky, may be a good actively managed bond fund which
can go well into junk territory when the manager is up for it. For
example, Loomis Sayles Bond fund. But again, look at what it did in
late '08. Top to bottom drop was something like 25% - less than the
equity market, but that's a *lot* of volatility for a bond fund. With
a 10yr total return annualized at nearly 10%, that trounced both the
equity markets *and* the Agg.

After all this, I've still got some thinking to do about how to
manage the fixed income sleeve. I definitely am leaning towards
lowering the TIPs allocation, but not removing it entirely. And
if I'm going to spend mental energy (and add risk) by actively
moving between fixed-income sub-classes (TIPs vs. Treasuries vs.
Corporates, and between short and long-term bonds), maybe there
is some value in leaving some of that to an active fixed income
manager (while, as usual, leaving a core position in BND or AGG).
 
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G

gordondi

I have been considering the option to invest my money in Mutual funds
but I don’t have any idea how much to invest first time in it? Can
you suggest some tips on that.
'Orlando financial planner' (http://www.roygavra.com/)




--
gordondi


======================================= MODERATOR'S COMMENT:
I'm permitting this, but (a) it's from "inveestmentbanter.com" and it's got a link to a NYLife insurance guy in it - both of which make me skeptical of it's seriousness.
 

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