Rethinking The Risk Free Rate (Part 2): A Free Lunch In Short Term TIPS?

Includes: SHY, STPZ
by: Lawrence Weinman

<< Return to Part I

Markets are tough, no doubt. The equities market seems to be facing more than a usual list of uncertainties. Treasury yields are basically nil on the short term and around 2% in the long maturities, while long term inflation protected bonds are offering real yield of .07%(!) For 10 years.

The bond market is considered a better forecaster of future economic conditions than the stock market. And the message of the bond market is pretty clear: We’re either in recession (or never got out of one in the real economy) or worse.

The only part of the picture that is missing is the classic indicator of a recession: An inverted yield curve. And we know the reason we don’t have that: The Fed is aggressively holding down short term interest rates. The current yield curve for nominal and inflation protected bonds is well below historical averages.

In this current constellation of market prices and yields some investors seem to be mesmerized by current dividend yields on U.S. common stocks, most of them from large well known (and well researched) household name companies. They can’t understand why people haven’t figured out that they can get a near perfect stream of inflation adjusted cash flows by buying a “select group” of stocks with high current dividend yield relative to stocks and bonds. So they reduce their bond holdings and load up on stocks with high dividend stocks in their new “retirement system."

Apparently pension fund managers and fiduciary trustees of the funds, the GAAP principals that govern pension accounting, the PBGC that insures pension fund liabilities, and annuity providers are part of a long list of the foolish ones. They haven’t figured out that a portfolio of high dividend stocks is better than bonds for meeting the cash flow needs of a pension. The zealots have found buried treasure that the pension fund managers missed. But it's not even buried. It’s sitting out in the middle of the highway.

I digress ... back to reality.

In my client portfolios I have dialed down the risk a bit. My current task is to scour the available on equity alternatives that allow the opportunity to pick up something more than the current 0% yield on cash with minimal principal risk. Call me crazy. But I don’t think the laws of risk and return ever really go away in any major way in financial markets. And one of the least likely places where risk and return would be consistently mispriced would be among large publicly traded U.S. stocks.

In my experience, one of the most fertile grounds for finding potentially mispriced assets is in fixed income. In fact, if there was an area where I would see the most potential for active security selection making a difference, it would be in fixed income. It is quite possible that there are individual bonds that have similar risk and return characteristics and slightly different price/yield. This is called basis trading, and it offers opportunity for low risk profits.

But it is very tough to do and basically impossible for individuals. I have worked in trading rooms with desks after desks of people spending hours of time with the most sophisticated computer systems and databases looking to pull out differentials of 10 bp (.10%) out of the market. And it doesn’t always work. To do this and consistently turn a profit you have to do hundreds of millions of dollars of bond trades at razor thin spreads with excellent execution to capture these differentials.

Many people that do make money in this activity get overconfident and add a lot of leverage. All of a sudden a position that would have made sense and been profitable had they held on creates unmanageable losses due to leverage and must be liquidated as a loss. This is the story of LTCM as explained in the great book When Genius Failed.

So where do I look? At times there are anomalies among asset classes of bonds that can be accessed through ETF strategies. In my last article I explained one of these strategies and the reason why I think it exists. The current confluence of Fed policy combined with the constraints of institutional investors is what I think provides the opportunity for the individual investor.

Another “Free Lunch?" Short Term TIPS

The concept of a risk free asset that I explained in my earlier article often is extended to include real (after inflation). Rational investors will demand compensation for their investment to at a minimum preserve their purchasing power. The chart below shows how - after inflation - returns have behaved for the last 30 years for tbills and 90 day treasuries.

Click to enlarge

It is pretty clear from the above that most of the time investors are able to get a small real return from investing in short term treasuries. The mean real return for Tbills in the U.S. from 1900 to 2010 averaged 1%.

(A note on data: You can find this info including similar data for stock and bond markets around the world in a really indispensable book: The Credit Suisse Global Investment Returns Sourcebook. If you are really interested in getting an idea of how asset classes behave it is a wealth of information with great data. A little more information about the book here. I learn something every time I pick it up. As an advisor approved to work with Dimensional Fund Advisors I also have access to its fantastic returns software which generated the graph above.)

Perusing the graph one can also identify a very disturbing trend: real yields have been collapsing and have gone negative since 2008. And we know the reason why. The Fed has been using the tool at its disposal to get the economy going by cutting interest rates. The Fed has a dual mandate - stable employment and moderate inflation. The Fed's long term inflation target is 2 -2/12%, while the long term average for U.S. inflation is a bit higher, closer to 3%.

Core inflation (PCE which is what the fed monitors most closely) is hovering near zero, inflation is in the double digits. It’s clear that the Fed is increasingly willing to tolerate the risk of inflation in an effort to get unemployment down. I won’t get into the debate over monetary policy but it’s easy to see one thing: Short term treasuries have become a very bad deal for investors. You’re not even getting a positive real return.

It’s also not too likely this situation will change. The Fed told us in the beginning of August it will keep rates low through 2013. Some outside of the Fed are arguing that in these dire economic conditions and political deadlock the Fed should target GDP or employment and let inflation rise a bit, even above the Fed's long term target. And now voices from within the Fed have been openly voicing the same idea.

In fact this week (Sept 7) Fed Governor Evans stated this explicitly:

I added the highlights in bold:

BOSTON - The Federal Reserve may have to let inflation overshoot levels consistent with price stability as part of a broader attempt to help stimulate the economy, a U.S. central bank official said. "The U.S. economy is best described as being in a bona fide liquidity trap," and given the challenges now faced by the nation, "much more policy accommodation is appropriate today," Federal Reserve Bank of Chicago President Charles Evans said.

As the Fed seeks to do more, Mr. Evans said it could gain extra bang for the buck by changing its longer-run inflation goal.

By saying that above-target inflation will be tolerated for a time, the Fed may be able to get an overly low level of inflation back to something more acceptable. But he cautioned that it would have to be a policy communicated with clarity.

Mr. Evans said that such a regime, which he called price-level targeting, "would be a helpful complement to our current and prospective strategies in the U.S. There are quite a number of academic studies of liquidity-trap crises that find either price-level targeting or temporary above-average inflation to be nearly optimal policies."

Amazing stuff. I wouldn’t exactly call myself a Fed expert or a professional Fed watcher. But I have spend 25 years pretty much monitoring financial news on a real time basis, either on a trading desk or in my current work as an investment advisor. I can never ever remember hearing something this explicit from a Fed governor. This was certainly not the kind of things you heard in the days when “the Maestro” Greenspan was in charge. He had little tolerance for public dissents and admitted in his autobiography that he spoke publicly with the goal of obscuring rather than enlightening the public as to his policies.

I have no idea whether an explicit change to employment or GDP targeting will be adopted. I tend to think not. But it does lead me to the conclusion that the data points on the above chart won’t be consistently positive after inflation returns for quite awhile.

Given that, what is the alternative for the investor looking for low risk and a positive after inflation return?

I think the place to look is in short term inflation protected bonds (TIPS), specifically with the ETF STPZ. STPZ is based on the short term 1-3 year TIPS index. Thus it would be directly comparable to SHY which is based on the 1-3 index of nominal (conventional non inflation adjusted) Treasuries. It seems pretty clear that the expected risk and return for getting a positive inflation protected yield favors STPZ over SHY. Based on long term data the long term after inflation return on short term treasury investments should be somewhere close to TBills = around 1%.

The current SEC yield listed for SHY is .07%

The current SEC yield listed for STPZ is -.99%

That STPZ yield may look daunting but in light of the current economic and monetary conditions the latter may be the better bet. But as I noted real yields are at historic lows and the goal here is to get as close as we can to a risk free real return.

Looking at the two yields above we can calculate the "breakeven" rate where the TIPS will outperform the conventional Treasury. At inflation above 1.06% the investor in STPZ is better off. His return will be 1.06 - (-.99)= .06. We know the Fed's target rate for inflation is 2 -2 ½% and as noted above there is a definite possibility the Fed may tolerate a higher inflation rate. And CPI can move around, the last reported CPI U was 3.6% on an annualized basis. Therefore the likelihood is the STPZ investor will wind up better off.

Thus it shouldn’t be surprising that the returns look as follows comparing the two.

Click to enlarge charts

In this environment every incremental benefit to a portfolio is important especially when it is low risk and an alternative use for cash "on the sidelines." STPZ merits a serious look as a place to park some of your money looking for a safe after inflation return.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: clients of mr weinman have positions in STPZ.