First Version from the Second Quarter 2009 Wescott Investment Commentary, Revised June 2014
One of our most frequently asked questions comes in the form of “Why doesn’t Wescott include a Treasury Inflation Protected Securities (TIPS) portfolio in its bond allocations? We have long been concerned that TIPS were vulnerable to a correction since investors seemed to put little emphasis on valuations and price. In 2013, TIPS had their worst annual return since they were launched in 1997. TIPS were negatively impacted by a modest rise in interest rates during 2013, and the persistence of low inflation. The worst performers in the bond market in 2013 were long-term U.S. Treasuries, with the Barclays U.S. Government Long Index down 12.48%. TIPS were the second worst-performing bond category, with the Barclays U.S. Treasury Inflation Protected Series (TIPS) Index down 8.6% in 2013.
We expressed concern in previous versions of this paper about how prices would be affected if interest rates rose. During 2013, we saw the impact of only a modest rise in interest rates. The Fed’s ongoing intervention made companies hesitant to raise prices or wages during a struggling economy, which has kept inflation subdued. During 2014, we have begun to notice a shift in these trends, with wage pressures in several sectors and with higher input costs passed on to consumers. Further improving economic conditions may compel the Fed to begin to upwardly adjust interest rates sooner than they have signaled in the past. In our view, until prices of TIPS become more aligned to their interest rate sensitivity, the inflation protection element of these securities may be little comfort to investors confronted with low or negative total returns on TIPS being bought under current market conditions.
Once interest rates return to more normalized levels, and inflation expectations begin to increase, our position on TIPS may change. In the interim, our bond managers have the flexibility to make allocations to TIPS in their portfolios when valuations are attractive. As part of our ongoing due diligence, we have tracked several TIPS portfolios including low-cost options from Vanguard and DFA. In 2013, Vanguard’s Inflation-Protected Securities Fund I was down 8.83%, while DFA’s Inflation-Protected Securities portfolio was down 9.27%. One of the hardest hit portfolios was the PIMCO 15+ Year US TIPS Index ETF, which was down 19.56% in 2013 due to the fund’s extremely long duration of 16.45 years. Underperformance of TIPS funds comes from expenses that are not reflected in an index’s return, and portfolios which have different maturity structures that can make them more sensitive to movements in interest rates.
Hazard #1: Too Much Demand for Too Few Bonds
Would You Buy a Bond that Pays a Negative Real Yield (Inflation Adjusted, of Course)?
Through December 31, 2013, the entire inventory of TIPS securities issued and not yet matured consisted of 28 TIPS bonds (maturing in more than 10 years), and 56 TIPS notes (mature in 10 years or less), for a current total of only 84 securities. Among the buyers are foreign central banks seeking to hedge their exposure to the U.S. dollar. Auctions are held quarterly, introducing new supply, which is offset by maturing issues. While stock investors have thousands of companies in which to invest, the available TIPS portfolios are all limited to the same pool of Treasury investments.
Investors in TIPS have been willing to accept paltry yields on Treasury securities in a herd-like flight to safety. We believe that many investors have an incomplete understanding of the true nature of TIPS. With buyers chasing the small group of available TIPS, they drive down yields, because they push prices up in the auction bidding process. On the other hand, when investors become skittish, the limited liquidity of TIPS causes TIPS to be vulnerable to sharp swings when there is selling pressure.
The opinions expressed herein were formulated based upon facts and conditions known as of June 2014. Subsequent changes in facts and conditions affect our analyses, opinions and actions.
The Pricing and Yields of TIPS
What is commonly known is that the principal value of a TIPS rises and falls with inflation. The Treasury uses the Core CPI, which does not include food and energy, to make the adjustments. At maturity of an individually held bond, the bond owner receives the greater of the inflation-adjusted principal, or the original face amount, or par value (which would happen after a period of deflation). In a taxable account, the investor pays tax annually on the non-cash principal adjustments.
What is less understood is how the auction process can experience such extremes from overwhelming demand that results in bonds issued at a premium (lowering the yield from the stated coupon), even to the point of a negative real yield at issue. In April 2011, auction rules were modified to provide that, in the event of an auction of a new issue at a negative yield, the minimum interest payment would be 0.125%. This followed the 2004 modification that put a floor of zero (0%) on the real yield of a TIPS. These rules do not apply to the reopening of outstanding issues. The Treasury has included “Information on Negative Rates and TIPS” on its web site, www.treasurydirect.gov.
TIPS offer some of the best examples of negative real yields accepted at auctions in 2013, since the demand for them has far exceeded the available supply. Six of the nine TIPS note auctions in 2013 executed at negative yields; one TIPS bond auction resulted in a yield of less than 1% for a 30-year maturity. The minimum interest payment of 0.125% applied to most of the TIPS notes auctioned in 2013. Of the nine TIPS Notes that were auctioned during 2013, only two of them sold for a price slightly under par ($100). They are highlighted in the chart below. It is important to note that the principal is protected through maturity, however, the market value of an outstanding TIPS will fluctuate when interest rates move and/or when there are changes in demand and supply.
These are some of the extremes in price and yield that investors have experienced in TIPS auctions to date:
For the 10 Year TIPS Note issued January 18, 2000, the interest rate was 4.250%. Investors paid $99.298 at auction, resulting in a real yield at issue of 4.338%, which to date is the record for outstanding TIPS. It matured in January 2010.
Of the outstanding TIPS, the highest price paid at auction for notes and bonds was $132.953 for the 29 Year Four Month TIPS Bond issued October 31, 2011. The interest rate at issue was 2.125%; the price paid resulted in a real yield at issue of 0.999% on a bond that matures on February 15, 2041. A bond of the same maturity issued a year later in October 2012 had a real yield at issue of only 0.479%, or half the 2011 yield! We do not understand the logic in accepting such a low real return to tie up principal for almost 30 years.
For the intermediate maturity range, to date the peak price has been $109.184 paid for a Four Year Four Month TIPS Note issued December 31, 2012, which resulted in a real yield of negative 1.496% at issue.
All securities, including bonds, respond to changes in demand. During the turmoil of 2008, TIPS saw both the best and worst of times. Two of the TIPS issued in 2008 carry interest rates of 0.625%, for terms of five years and 4.5 years, respectively. Investors in the Five Year TIPS issued on April 30, 2008 paid $99.56, or almost par, with a real yield of 0.745% at issue. Only six months later, the demand for TIPS was much weaker. Investors paid only $92.38 for the Four Year Six Month TIPS issued on October 31, 2008, resulting in a real yield of 3.270% at issue. Both notes matured on April 15, 2013.
Two securities, almost alike, had very different auction outcomes for investors. If both investors held the bonds to maturity, they received the same proceeds. Yet the October 2008 investor had a much better return on invested capital, and was better protected from market loss had the bond been sold before April 2013 because the price paid for the bond at issue was so much more attractive.
Hazard #2: The Impact of Rising Interest Rates—When Yields on New Bonds Rise, Down Goes the Value of Old Bonds with Lower Yields
TIPS maintain a real return equal to the interest rate at issue. They protect against inflation, not against rising interest rates. The table below compares two portfolios of TIPS that we track. Based on data available, both have low expense ratios.
What is Significant About the Portfolio’s Duration?
The portfolio’s duration (or the years to maturity of an individual bond) helps an investor anticipate its interest rate sensitivity, or by how much principal can change for each 1% change in interest rates. That is, for the port- folios above, a 1% decline in rates can boost its value by about 8%, whereas a 1% increase in interest rates can cause principal to decline by about 8%.
Unlike individual TIPS, mutual funds (including ETFs) have no maturity dates; the portfolio manager buys and sells TIPS in a portfolio based on valuations that make economic sense. The value of the underlying holdings fluctuates each day within a portfolio, affected by cash flows (investments and redemptions), changes in interest rates and demand, and the auction results for new issues in which cash flows can be invested. The yield of the mutual fund portfolios shown above is much higher than what can be obtained at current auctions because they own older securities issued when yields were higher. This is not a bargain for a new investor, however, since the current net asset value is based on the higher prices at which these bonds are priced due to the decline in interest rates that we have experienced since they were issued.
The performance history of TIPS has been volatile, particularly since the 2008 credit crisis. Volatility during 2013 was in response to former Fed Chairman Ben Bernanke’s Congressional testimony on May 22nd, which triggered a pullback in equities and a panicked exit from bonds. Vanguard’s TIPS portfolio was down 4.3% in May and a further 3.94% decline in June; DFA’s TIPS portfolio was down 4.4% in May, followed by an additional 4.43% decline in June. For the year, TIPS had six months of negative performance in 2013 (January, May, June, August, November and December).
If you like to avoid roller coasters, you should steer clear of TIPS during this period of historically low interest rates, which has persisted for more than five years. This was not the first time we observed turbulence in the returns for TIPS. During the second half of 2008, TIPS had three months of negative performance, with the Vanguard and DFA portfolios each down 8.9% in October 2008. However, total returns in 2008 were less severe, with Vanguard’s portfolio down 2.8% and DFA’ s portfolio down 1.4%. During 2009, TIPS experienced negative returns in three months (February, April and December). Bond market volatility during the fourth quarter of 2010 also affected TIPS, with the PIMCO 15+ Year US TIPS Index ETF down 9.27% for the three-month period ending January 31, 2011. During 2012, several of the most popular TIPS funds had negative returns in five months (February, March, June, August and December).
We continue to experience historically low interest rates as the result of the ongoing support of the Federal Reserve. With monthly purchases of Treasury and mortgage-backed bonds expected to end by October 2014, the reinvestment of interest and principal of maturing bonds has no established end date. Following the credit crisis, every market tremor sent investors rushing to the perceived “safe haven” assets of Treasuries. The August 5th, 2011 announcement that Standard & Poor’s had downgraded U.S. debt to AA+ did not reduce the demand for Treasury bonds. At some point, however, the perceived safety of these overvalued securities should be questioned by investors.
When the Federal Open Market Committee announced its intention in September 2012 to keep the federal funds rate between 0% and 0.25% until mid-2015 (which was extended from mid-2013), this spurred demand for TIPS, as did the prices that investors were willing to pay for them. In December 2012, the Fed gave more specific targets for its interest rate policy, which was guided by getting the unemployment rate to 6.5% or lower, and keeping inflation below 2.5%. At year-end 2013, the unemployment rate was 6.7%. Early in her first term, which began in January 2014, new Fed Chair Janet Yellen signaled that improving unemployment numbers will not prompt the Fed to start raising rates, since the goal is to ensure that the economy is on strong footing before doing so.
During 2014, the unemployment rate has continued to decline and has fallen below the Fed’s target of 6.5%. With signs of a stronger economy percolating, we believe that the Fed may find itself moving up the timetable for raising rates from mid-2015 to an earlier date. If history is a guide, they are likely to do so in small increments, however, even a 0.25% increase would be a jolt to the bond market given current short term rates.
The Fed cannot control market forces that can lead to higher yields, for example, when investors begin to require a higher return for lending the government money for extended periods. While we may see rates remain low near-term due to the Fed’s intervention, we expect that interest rates in the future will be higher than they are today. The principal value of a TIPS adjusts with inflation, but the market value responds to changes in interest rates and demand.
We have an ongoing interest in TIPS (particularly in a global strategy that makes more securities available for diversification), and may incorporate a TIPS strategy within our fixed income allocations in the future. Until then, we consider a dedicated allocation to TIPS as too volatile and too low yielding to make sense for investors seeking safety of principal. Keep in mind that TIPS are taxed on the non-cash annual inflation adjustments and on the income for federal income taxes. Effective January 1, 2013, the 3.8% additional Medicare tax on taxable investment income began to affect investors. The pain was first felt in filing 2013 income tax returns when income exceeded the thresholds. For these reasons, we would consider a TIPS strategy more appropriate for tax-deferred accounts when prices become reasonable.
An original article authored by the Investment Research Group of Wescott Financial Advisory Group LLC
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