Bond Market Liquidity

We typically think of Treasuries as being very liquid - by which we mean that an investor can buy and sell a large quantity of the asset with little impact on the price.  We're also implicitly assuming that there is no new information about the asset's fundamental value.

So look what happened recently for TIPS (Treasury Inflation Protected Securities) when Bill Gross, Chairman of PIMCO (one of the biggest fixed income management shops) quit.  

The day Gross left Pimco to join Janus Capital Group Inc. (JNS), Mexican government bonds declined 0.3 percent, inflation-protected U.S. bonds lost 0.4 percent and debt of Verizon Communications Inc. (VZ) -- one of his bigger company holdings -- dropped 0.3 percent. That compares with a 0.05 percent decline on the Bank of America Merrill Lynch Global Broad Market Index.

and

“Less liquid sectors such as TIPS continued to weaken as a result of Pimco concerns,” Leduc wrote in a Sept. 30 note. “There has not been measurable impact in most liquid sectors.”

Article here;  http://www.bloomberg.com/news/2014-10-01/gross-exposes-42-trillion-bond-market-s-key-flaw-in-pimco-exit.html


If we look at the real rate of return on TIPS since they were first issued, we can see that the real return has declined over the years.   This could be due to a secular decline in real rates, but is also, at least in part, consistent with some liquidity premium being present in the TIPS yield.

Questions about TIPS

Marginal Revolution asks some interesting questions about TIPs and inflation.

TIPS are unattractive

A great blog post from a new (to me) blogger, The Calafia Beach Pundit, who talks about what the negative real return on TIPs means for investors.

He concludes:

To sum up: TIPS are only attractive to an investor who believes 1) that inflation will prove to be higher than expected, and 2) that economic growth will continue to be disappointing

Thanks to Ben (one of my MBA students) for sending me the link.  We talked about TIPS this week.

Playing it safe as a long term strategy

An interview with Zvi Bodie who advocates for a very conservative approach in retirement planning.

Treasury considering floating rates notes.

Very interesting.  Yet another thing to cover in the bond lecture!  Of course higher interest rates mean that the Government's liability would increase (As Campbell Harvey of Duke notes in the article), but this is already the case with TIPS, so I would wonder to what degree investors would actually just substitute these new bonds for TIPS.

(reposted from financeprofessor)

Inflation linked bonds are back in the spotlight

With global concerns about inflation, the attention turns, predictably, to asset classes that are good inflation hedges.  The FT has a good article on the topic.   Mechanically, inflation linked bonds will provide inflation protection.  But they have a problem - only part of their nominal return comes from inflation - the other part is a real return.  Currently the real return on US inflation linked bonds is basically zero.  If demand for TIPs increases this could go negative (it has in the past).  

Alternatives to TIPs include any real asset.  For example, in the long run, stocks are excellent inflation hedges, although in the short run they often do poorly, in large part because investors don't understand that they are real and not nominal assets.  Commodities are good hedges - but very volatile.  

At the end of the day, trying to bet on inflation is a risky business.

The low real return on inflation linked bonds.

Jeremy Siegel discusses the near zero (and in some cases negative) real return on TIPs and what this means for investors. (source: Financial Times)

First, a bit of background:

• Siegel is a Wharton Professor who is famous (in the finance world) for his book "Stocks for the long run".  Siegel is a strong believer in stocks being excellent long run inflation hedges.  
• TIPs are inflation linked bonds that earn a real return plus the rate of inflation.  The inflation return is certain - the uncertain part is the real return that you earn.

OK, back to the article.  Siegel argues that the low real return on TIPs is due to the low level of economic growth.  This makes sense because it is broadly the case that the real rate of interest should roughly equate to the real growth rate.  He argues that as the economy improves, real growth will increase and so will the yield on TIPs.  Of course, as any student of bond math knows, an increase in rates will result in a drop in the price of the bond.   Siegel argues that the drop in the price of TIPs is all but inevitable as the economy improves.  His solution is to sell TIPs and buy stocks.

His argument has merits, but moving from TIPs to equities will substantially increase the risk of a portfolio.  So while you might dodge an as yet uncertain rate increase on TIPs, you'll expose yourself to much greater market risk.  Furthermore, other fixed income securities would come off worse than TIPs as they would be negatively impacted by both real rate increases and inflation rate increases.

TIPs selling off negative yields

So the big news in the world of TIPS (inflation protected bonds) is that they are selling off a negative yield.  To be clear, this is the real return, not the nominal return on these instruments.  The view is that investors are willing to accept a negative real return in exchange for at least some inflation protection.
My colleague, Steve Allen expands upon this...



HT: Mike (one of my students)

Perpetual Bonds

A nice piece today from one of my favorite Finance bloggers, Felix Salmon. Felix talks about perpetual TIPs and whether the government should issue them. Perpetual TIPs would be inflation linked bonds that never mature. Sort of like inflation linked preferred stock. The example given is for a bond paying an annual coupon of $120 in a world of 2% inflation and 2% real return.

The nominal return (from the Fisher equation) would be (1.02)(1.02)-1 = 4.04%

We could value the perp TIP in two ways.
First treat it like a growing perpetuity (that grows at the rate of inflation):

Price = cpn(1+i)/(R-i)
where i=inflation, and R=nominal rate. In this case the price would be:
6000 = 120(1.02)/(0.0404-0.02)

Alternatively we could value it in real terms and ignore inflation because inflation affects both the growth rate of the cash flow and appears in the nominal discount rate:

Price = cpn/r
where r = real rate of interest.
6000 = 120/0.02 = 6000.

The problem with a perp TIP though is that the duration (sensitivity to interest rate movements would be quite high. A 100 b.p. increase in the real rate would cause you to loose 1/3 of the value of the TIPs.

From a retirement point of view, I think Duration matched TIPS portfolios make more sense. This is an idea promoted by Zvi Bodie and apparently implemented at Boston U. With those I could buy a portfolio of TIPs that would be immune to interest changes provided I held them for the correct holding period.

More on the negative TIPs yield

The self evident blog argues that the negative TIPs yield is a rational response to the volatility in the "traditional" inflation hedge markets such as gold and real estate. In other words, investors are accepting no real return in return for stability, something which can't be found anywhere else.

The great one liner...

In short, the negative TIPS yield is a rational reaction to the lunatic casino that has infested essentially every market in the world.

Uh Oh. Negative real TIPs yields...

Felix Salmon talks today about negative real TIPs yields.

What does this mean? Well basically investors are happy to park money in TIPs just to keep pace with inflation. They are not actually earning a real return.
Why would investors do this? Perhaps there aren't any better places to put cash right now.

So overall this probably isn't the greatest news...

Why you should consider TIPs

for a retirement portfolio.

For my MBA students - The Bodie quoted in your article wrote your text book.

What is a good hedge against inflation?

TIPs are good. But there is the uncertainty about the real rate.

Fama and French discuss the pros and cons.

Expected inflation

It is possible to estimate expected inflation by looking at the spread between TIPS and T Bonds. Here is a link that presents the data in a pretty clear way.

HT: Craig Newmark

Is high inflation around the corner?

Probably not. We talked about the spread between TIPS and Long Government bonds in class this week and in particular how this spread is only about 250 basis points. This spread represents the market's expectation of inflation embedded in bond prices.

Greg Mankiw makes the same point in his article tomorrow (Sunday) in the New York Times. You can read it here.

Do TIPs provide inflation protection...?

TIPS - Treasury Inflation Protected Bonds are designed to provide inflation protection to investors. These US government bonds have par values that increase at the rate of the CPI each year. Because the par value increases, the coupon payment also increases. Thus the payment you get is, in effect, indexed to inflation.

Jeff Opdyke of The Wall Street Journal asks - "do these bonds provide inflation protection?" Its a good question, however I think that Opdyke's analysis has some problems.

First he points to the fact that the CPI is an imperfect measure of inflation. This is absolutely true, for example the CPI doesn't include extra bag fees for airlines. But I disagree that a flaw in the index is that it doesn't include borrowing costs. The CPI specifically doesn't include borrowing costs, in part because using a cost that is directly related to inflation in the index would lead to a feedback loop. Furthermore, when mortgage rates increase, the higher borrowing costs are offset by house price appreciation - so it is unclear whether a household's costs have truly increased.

A second point raised is that if you sell the bonds before they mature, you are not guaranteed the promised return. As my students should know, this is incorrect. To earn the initial yield to maturity you need to hold bonds whose duration is equal to your holding period. Holding the bonds to their maturity exposes you to reinvestment risk from the coupons. Zvi Bodie has talked about this issue and advocates target date duration matched TIPs funds for retirement.

Finally, Opdyke argues that 3% tips would underperform 5% tips in an environment where rates increase. We have to be careful here. If the rate increase is just due to higher inflation, then there will be no difference in the real return on these bonds. But if the increase reflects a higher real rate of interest, then the lower coupon bonds will be hurt more because they have a higher duration.

Overall though, this is an interesting article and well worth a read.