Superior Inflation Protected Securities Allocations

Includes: GLD, PFK, PRU, SLM, TIP
by: Dan Plettner

I am not a consumer of the insurance products sold by Prudential (NYSE:PRU). However, Prudential is effectively paying me to insure my own financial portfolio against inflation.

I own Prudential Inflation Linked Notes (NYSE:PFK) currently trading at $22.20. Technically, PFK is an exchange traded debt security. In addition to paying a monthly coupon linked to inflation, the notes mature at $25 on April 10, 2018.

PFK today presents superior risk-adjusted return characteristics versus the Treasury Inflation Protected Securities “TIPS” (NYSEARCA:TIP) or Gold (NYSEARCA:GLD) exchange traded fund “ETFs”, in my view.

Categorically, PFK is an "Inflation Protection Security", like TIPS. However, PFK was issued by Prudential and its trading volume caused it to fall off the radar screen of financial media or institutional investors who need the ability to move around large pools of capital.

Careful examination of PFK’s preliminary prospectus reveals that each of its monthly coupons is based on year-over-year Consumer Price Index (“CPI”) inflation, 3 months prior. PFK trades largely on current yield, similar to bonds and preferred stocks. You may be surprised to learn that exchange traded bond securities are sometimes referred to as preferred equity traded bonds, relating them to less-safe preferred stock. However, because it is debt (think “bond” just like Treasury version TIPS), all exchange traded bonds including PFK have balance sheet seniority to preferred stocks.

Credit quality is very important to me, particularly as relates to the investment utility for which I contemplate TIPS. Still, I should note that there is another Inflation Protection Security issued by Sallie Mae (OSM), which is cheaper. I am disinclined to own a significant amount of OSM near current prices, or significant amounts of any Sallie Mae debt at all. I would encourage retail investors to take heed of broader debt market pricing and be skeptical of Sallie Mae credit quality generally. In contrast, Prudential Financial credit quality is such that 50-year-longer term exchange traded debt (PHR) actually trades about 8% higher than the future redemption price.

Making matters more clear in regards to my preference, Sallie Mae was assumed to have government creditworthiness at the time of OSM’s issue. Not the original prospectus, but the pricing supplement of PFK makes clear that PFK pays 2.4% over the relevant inflation calculation (40 basis points more spread than does OSM).

The Catalyst

Let me be clear of the relevance to the “3 month prior” element of the coupon calculation. This element is neither referenced to significantly in the pricing supplement, nor at all on PFK’s summary page on what I believe to be the investor help for exchange traded income securities. From March through October of 2009, CPI data showed year-over-year deflation (the opposite of inflation).

Take a peek at where the PFK monthly coupon was for the October 28th ex date (only $0.006 cents). Can you appreciate why the unsophisticated retail base has treated PFK as a zero-coupon bond, or simply instead looked for higher yielding Exchange Traded Issues as most assets worldwide have rebounded from March’s liquidity crises when the very survival of even insurance companies was questioned by sellers of anything and everything

October represented an inflection point where year over year deflation became negligible. November and December year over year CPI data shows tame inflation. For relevance to the monthly coupons, simply count forward 3 months.

Higher yields are factually coming to PFK holders. The uncertainties include “how much higher?” and “how long will we be in an inflationary environment?" In assessing the CPI historical table above, remember that 2009’s deflationary period sets up some low denominators for calculating each months year over year inflation for 2010. What PFK’s pricing supplement does offer (which its preliminary prospectus lacks) is the notation that PFK adds 240 basis points (2.4%) to 1 year like-month CPI inflation (modified from 200 basis points in the preliminary prospectus).

The Art of Anticipating Dividend Changes

In my view, anticipating actual coupons is very important to market returns because so few investors are forward-looking outside of single company common stocks. We have just exited deflationary period, and inflation is just beginning to show up in year over year like month figures. Such inputs are positive for the direction of PFK’s nominal monthly payments, and possibly an even more positive for PFK’s market price.

I have also used the art of anticipating dividend changes in formulating a recent cosed-end fund thesis.

Rationale for Inflation Protected Securities

The most recent FOMC minutes generally confirm that the Fed is more concerned with keeping traction for economic growth than common sense knowledge that easy money has a positive correlation with inflation. Historically normal rates that historically combat inflation risks will eventually serve as a headwind to economic growth.

My portfolio decisions are being influenced by my neural opinion that our policy creating stewards are going to skip rounds 1 through 3 of a 15 round bout (boxing analogy) with inflation. I believe our governmental stewards are picking their battles, and trying to talk down the real risks and perceived risks of the battles they don’t pick.

Disclaimers and Article Relevance

It would be professionally futile for me to discuss PFK with an institutional investor; institutions can not invest in PFK with meaningful size. What I can do with this article on PFK is display my own research and analytical skills -- without giving away any actionable institutional research. Any individual investor readers should remember that I am not their Financial Advisor. To the extent this article interests them, they might consider evaluating the article (and their Financial Advisor) by discussing the article's merits. Free insights are often worth less than you pay for them, but I will also encourage talking to Financial Advisors about the importance of using limit orders and considering alternatives such as PFK only for longer term portfolio allocations.

Disclosure: Author holds a long position in PFK and a small position of intrique in OSM. No other positions in securities mentioned.

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