Tips on buying inflation-protected bond funds
21 March 2010
When the economy is awash with cheap money, the risk of inflation eroding asset holdings is bound to spook investors. No wonder then, inflation-protected bond funds available for sale in Hong Kong have gained prominence of late. But how efficient are they? To understand that, it might be worthwhile to look at the pros and cons of Treasury Inflation-Protected Securities (Tips).
If there is one thing that every Tips fund investor should know, it is this: they do not offer guaranteed protection from interest-rate risk.
Confusing their inflation-hedging ability with an ability to fight off interest-rate volatility is an error investors have been making since Tips first hit the United States market in the late 1990s. As much as they are linked to each other, though, inflation and interest rates are not the same thing.
Before we look at why that is so important, here is a quick refresher on the difference between regular, or nominal, Treasury bonds and Tips. Like regular Treasury bonds, Tips are issued with a face, or par, value of US$1,000. And also like regular Treasury bonds, they distribute coupon, or interest, payments that are expressed as an annual percentage rate of the par value.
One of the key problems with regular treasuries, of course, is inflation. If a Treasury bond’s coupon payment is 5 per cent and inflation is 2 per cent, the so-called real yield is actually only 3 per cent. Of course, the age-old problem with that is the investor is taking a chance that the coupon payment, which is fixed over the life of the bond, will not keep up with a surge in inflation. If inflation in this example turns out to be 3 per cent instead of 2 per cent, it will eat into your real yield.
Enter Tips. Instead of leaving to chance the question of how much of a Treasury bond’s return will be eaten up by inflation, Tips promise investors that their principal value will rise with the consumer price index. That guarantees investors’ principal will keep up with inflation, and because Tips’ yield payments are still calculated as a percentage of that principal amount, their value can move up with inflation as well.
So, why is it that, if their principal values are linked to CPI, Tips are still sensitive to interest-rate shifts? Interest rates and inflation rates do not have to move in unison. Just like a regular Treasury bond, a Tips’ price is also affected by how much income – in this case, the real yield – it is going to produce over the course of its existence. So, if nominal Treasury yields rise because inflation spikes, Tips are protected. But if nominal yields are driven higher because of rising real yields, Tips are much more vulnerable.
If you look at the mathematically calculated duration of a Tips portfolio or index, you are likely to see a number that looks pretty long.
Say you have one with a six-year duration, implying that for a 1 per cent rise in market yields, you would expect the portfolio’s price to fall by 6 per cent. That number only has meaning with respect to changes in real yields, though, not nominal Treasury bond yields and not inflation. And most of the time, changes in real yields are not as sharp or as large as they are for regular Treasury bonds. That is why, in the early years of the Tips market, it was common to hear that Tips were about 25 per cent to 40 per cent as volatile as regular Treasuries.
The 1990s was a different time, though, and one during which real yields were much higher, typically between 3.5 and 4 per cent. In those days, the Tips market was not as large or as actively traded, and real yields did not move all that much.
Today, however, real yields are down in the 1.5 per cent range, in part because so many people have bought Tips for their inflation protection, thus driving their prices up and their real yields down. In fact, last year was the biggest year for inflows to Tips-focused funds, with more than US$18 billion flowing into the category.
It is crucial to understand that if real yields for nominal treasuries and other securities do rise broadly at some point, they will begin to provide a more generous alternative to investors than the 1.5 per cent being paid by Tips. That is just another way of saying that for Tips to remain competitive, their real yields will likely have to go up too.
What will that mean for Tips prices? As noted earlier, if one has a Tips portfolio with a duration of six years and real yields rise 1 per cent, then one would expect that portfolio to suffer a 6 per cent loss. A 2 per cent change in yields would imply a 12 per cent loss.
Do any of these percentages call into question the case for owning Tips as a long-term inflation hedge? The answer is not at all. It does, however, argue that one should not confuse Tips with a hedge against day-to-day interest-rate volatility. That is one thing they definitely are not.
Eric Jacobson is Morningstar’s director of fixed-income research