Any TIPS on a Good Inflation Hedge?

Jeffrey Addis:

Welcome to our podcast. My name is Jeffrey Addis. I’m the Chief Operating Officer of Merganser Capital Management. Before we begin, a few important regulatory disclosures. This presentation is for informational purposes only and should not be considered as an investment advice or a recommendation of any particular issuer, security, strategy, or investment product. Now on to our podcast.

Andy Smock:

Hello, my name is Andy Smock. I’m the CIO of Merganser and I’m here with Todd Copenhaver, Deputy CIO and head of credit. We’re going to talk a little bit about inflation and ways to protect against it and potentially hedge. To set the table though the Fed has an explicit inflation target of 2%. For decades, inflation has continuously missed that target despite periods of very low unemployment that would’ve previously suggested a rise in inflation. In fact, deflation has been a greater worry than inflation until just recently.

So, what changed? Starting in 2020, we faced massive demand in supply and balance. Fiscal stimulus in 2020 and 2021 filled consumer pockets and with fewer services such as restaurants to consume there was a huge spike in demand for goods from home improvement materials, Amazon deliveries to cars. That’s the demand side. Simultaneously, the supply side contracted due to labor shortages, lockdowns, and other supply chain constraints. This combination is a classic setup for inflation.

Fast-forward to 2022 and we add to those continuing pressures, a war that is spiking energy prices. The world still runs on energy and gas and higher fuel costs, further pressure inflation. Oil prices have moderated a little bit, but they’re still very elevated. So, here we sit with inflation at 40 year highs and making investors nervous. What can we do about it? Since Merganser is a fixed income manager, let’s start by digging into TIPS, treasury inflation protected securities as a potential inflation hedge. We’ll then touch on a few other inflation hedges at the very end. So Todd, can you give me a little bit of background on the TIPS market?

Todd Copenhaver:

Sure, TIPS, treasury inflation protected securities have been around since the late ’90s, 1997, and are a unique element of the fixed income market where they adjust to realized inflation, both in income and principle at maturity. For TIPS, the measure of inflation is the consumer price index, notably different than the personal consumption expenditures index that the FED is focused on that 2% target. CPI generally is higher than PCE because it includes the more volatile components of food and energy, which are particularly notable in this market. As inflation is realized higher, the income from the bond is going to adjust higher, and the principle that you get paid at the end is going to adjust higher. If there is deflation, there’s going to be no adjustments higher or an adjustment downward, depending on the bond. And with that, some amount of lagging versus nominal treasuries.

Andy Smock:

So, in a way it’s a little bit of an asymmetric payoff where you can benefit from inflation, but there’s no decrease in par value for deflation?

Todd Copenhaver:

That’s correct. One of the things that makes the TIPS market require a more quantitative approach is that there is that asymmetric payoff profile that makes them a little bit more complicated than a traditional treasury bond.

Andy Smock:

So, if I’m looking at a Bloomberg screen or looking up TIPS on websites, I see break-evens, can you talk to me what that means in relation to some of the mechanics that you’re discussing?

Todd Copenhaver:

Absolutely. So, break-evens are a market heuristic for what the relationship between traditional nominal treasuries and TIPS are. In essence, it represents the amount of annual inflation necessary for a TIPS bond to meet the performance of a comparable maturity nominal treasury, traditional treasury bond. In the current market the break even for 10 year TIPS versus nominal treasuries is roughly a high 2% level, as of today around 2.8%, meaning that annual inflation, as measured by CPI for the next 10 years, must be at least 2.8% for the TIPS bond to match the return of a traditional 10-year treasury note.

Andy Smock:

So, if you bought a security today, a TIP today, you’re really only getting a hedge from inflation, if you will? If inflation is higher than what’s already priced-in today.

Todd Copenhaver:

Yes, that’s right. Actual inflation must exceed the breakeven to outperform nominals over the life of the bond.

Andy Smock:

So, in a traditional treasury, one of the classic relationships in fixed income is yields rise, prices fall, and it’s pretty easy to get your arms around that with a 10-year treasury, nominal treasury. Isn’t that also true with a TIP?

Todd Copenhaver:

It really depends on what rate you’re talking about. One of the other ways that the market refers to TIPS are real bonds that respond to real yields. You can think of interest rates is having two components, the real yields and then the inflation component. So, TIPS strip out the inflation component are just left with real yields. So, if real yields in the market are rising, then both the TIP and the nominal treasury will fall at the exact same rate holding all sequel. Whereas if nominal rates are rising because of higher inflation expectations, but real yields are staying the same, then the TIPS bond will have very little impact where the traditional nominal treasury will decrease in price. So, that separation of those two components of yield generates that differential. But it’s very important to note, when thinking about TIPS in the context of a hedge against rising inflation, you are taking on that real yield risk and as much duration as you have to inflation protection, you have an equal amount of interest rate exposure to go along with it.

Andy Smock:

So, inflation’s going up and interest rates are going up. Clearly tenure treasuries get hurt. It sounds like using a lot of a simplifying assumptions that the tip might be more neutral, but neutral doesn’t really make it sound like a great hedge. Usually you think of a hedge as going up at a time when something else you’re trying to hedge is going down.

Todd Copenhaver:

Yeah, I think TIPS are best described as a hedge against changing expectations of inflation. In traditional bond math terms, price changes in bonds are the pull forward or pushback of the future. And so, if expectations are changing, which is extrapolating out to the future, that’s going to be a more instant gratification change in the return profile of the tip bond. Whereas the realized inflation changes over time is more of the horizon and you’re going to get that each year, each semi-annual period when you get your coupon and eventually the principle. So, when you think about changing expectations, that’s going to be the instant gratification of that hedge, but the expectations need to be dynamic for that to be realized.

Andy Smock:

So, it sounds like if you’re stuck within a fixed income world, which many investors are, whether by a mandate or statute or some other limitation, and you want to protect against inflation, then TIPS are pretty good at helping downside protection, at least relative to nominal treasuries and potentially other fixed rate securities. How’d you think about floating rate securities in that context?

Todd Copenhaver:

So, I think about floating rate securities in that context as a less levered version of TIPS in that regard where interest rates, nominal interest rates are highly correlated with inflation over time. So, as inflation rises, and we’re seeing this in the current market with the Fed approaching and enacting liftoff, that interest rates are rising in the face of inflation as the feds trying to fight inflation. But your leverage to that, as measured by duration, is significantly lower. So, you’re going to benefit but with less of a multiplier impact that you would have with the TIPS bond. So, less of a multiplier equals less risk, but in terms of bang for your buck, the TIPS market is what’s going to provide you the strongest touch.

Andy Smock:

And TIPS were introduced in ’97, when were treasury floaters introduced?

Todd Copenhaver:

Treasury floaters were introduced to the market in 2014 and have become a staple of the shorter term treasury issuance profile issued quarterly.

Andy Smock:

So, both of which are new innovations by the treasury and new options for investors. Since the last time we saw a very heated inflation in the seventies and eighties. What would you say now, stepping away just for a moment away from fixed income, there’s talk of gold and Bitcoin and real estate. If you don’t have to invest in fixed income and you can move elsewhere, do you have any thoughts on places to go?

Todd Copenhaver:

Generally, we find that the best inflation hedges are those that are outside fixed income. Traditionally value stocks, which are less correlated to the impact interest rates and have better defined cash flow than growth stocks, are a good inflation hedge as well as commodities themselves. With that additional protection against inflation, you’re taking on significantly more volatility. And for many investors, that is a mismatch of the role that inflation hedges play within the broader portfolio context.

Andy Smock:

Thank you very much. That concludes our quick chat about TIPS. There’s a lot more to discuss and we’d be pleased to do it with any of the listeners in person. Thank you, Todd, for taking the time to chat with me.

Jeffrey Addis:

This commentary contained or incorporated by reference certain forward-looking statements, which are based on various assumptions, some of which are beyond our control. Opinions and estimates offered constitute our judgment and are subject to change without notice as our statements of financial market trends, which are based on current market conditions. No part of this presentation may be reproduced in any form or referred to in any other publication without the express written permission of Merganser Capital Management. For more information, please visit our website at www.merganser.com. Thank you.