RiskTrade

TIP ETF: A High Dividend Stock and Inflation Hedge?

JAH,
As you say TIPS have an inflation factor determined by the MoM CPI figure. This factor is used to adjust the principal upward upon which the stated coupon is calculated thereby leading to coupon income that is indexed to inflation. Hence TIPS keep their value when inflation occurs as the numerator (i.e the indexed coupon cash flows) increases when inflation occurs. However that is only the numerator element of a TIP. The denominator is the interest rate at which you discount cash flows (i.e the respective nominal treasury rate) Hence as the central bank increases interest rates in order to reduce inflation the PV of each coupon payment and the final payment at maturity decreases. This is basically encaspulated in the TIPS interest rate duration. Hence when interest rates rise TIPS will decline in value if the effect of the indexed coupon does not offset the increase in the nominal rate. As TIPS have positive duration both in response to a parrallel shift in real yields and nominal yields they will decline in price if interest rates increase significantly.





On Jan 28 05:36 PM jhowle wrote:

> puttster: It could be a good reason, the logic is that if interest
> rates are up it is because of a rise in inflation. The 2 do not necassarily
> move in tandem. When you buy a TIP bond you are simply locking in
> a 'real rate of return' over and above an expected positive inflation
> rate. If inflation goes negative you can earn no interest but the
> Treasury will pay you back par value. Be warned that the older TIPs
> bonds have accrued inflation factors and that value can go down.
> Be careful out there.
>
> JAH

TIPS: The Swiss Army Knife of the Bond Market

I bought TIPS in October as breakevens were negative at the time but recently sold my position. If you start by taking the view that the market is rationale and collectively the market is smarter then individuals then it would stand to reason that at any point in time the market is fairly priced. By this I don't mean that you can't take a view that will make money as variables change but only that at any point in time the market accurately reflects all publicly available information (i.e. markets are efficient).

If you agree with this, then the question is not whether or not inflation is underpriced but rather why does the market reflect this level of inflation expectations ?. As you point out the reason is deflation expectations. The market is now coming to grips with the fact that deflation is likely over the forseeable future. What we know today is the MoM deflation numbers are likely to be negative and therefore the income I recieve from purchasing a TIP is likely to decline in the forseeable future. The author claims that one should invest in TIPS as 10 year breakevens are historically low. This is true but it doesn't mean that the markets estimate is wrong. It is very possible to have inflation average 1.25% over 10 years if you have a period of sustained deflation in the initial years. A sustained period of deflation is likely as people lose their jobs and ability to purchase goods and services.

The Federal reserve has cut interest rates to historic lows to get the economy moving again. When the economy moves again the Fed will raise rates quickly to stem inflationary pressures. Hence as a TIPS holder you are betting that a) The markets estimate of inflation is wrong and b) risking lower coupon income should deflation occur c.) betting the fed won't be able to curtail inflation risk in the future by raising rates quickly enough d) taking interest rates risk (duration risk) as rates will need to rise in the future and e.) uncertainty about when inflation will finally occur ( if you have to wait 5 years then isn't TIPS as an asset class as attractive as any other asset class).

Given, all the risks involved - may be thisn't the slamdunk investment that everyone thinks it is?

Thoughts on Mohamed El-Erian's 'When Markets Collide'

Nothing new here. Also El - Elrian has it wrong. In today's world the U.S is the new emerging market. U.S investors today face a risk profile that would suggest higher then average risks and hence potentially higher then average expected returns. So if El- Elrian really believes that emerging markets are the place to invest - then I wonder how soon it will be before he starts loading up on U.S stocks ?