The new investment benchmark

Just about everyone in the US, should get a mortgage on their house. OK its best not to have any debt at all and the less the better, but mortgages are a great deal. Not only do you get a low borrowing rate as the mortgage loan is secured on your house, but the effective rate you pay is even lower as mortgage interest is deductible against your income taxes. But that is not all. You also own a highly valuable option. When you fix the interest rate on you mortgage you have the option if interest rates fall of prepaying your mortgage and getting a new one at a much lower interest rate. If interest rates rise you are locked in and have the option of keeping your mortgage at below market interest rates. With a mortgage you are 3 times a winner. You have a low rate, a tax subsidy, and a highly valuable interest rate option.

Starting on October 26, 2004 the Treasury begins to issue 5 year TIPS (Treasury Inflation Protected Securities) on a semi-annual basis. This will provide investors with many new unique opportunities to manage their assets. In the same way that most people should have a mortgage, just about everyone should own some 5 year TIPS. Once again you are three times a winner. In addition you have all the best risk/return characteristics in the bond market working in your favour as we’ll explain, and these new short maturity TIPS have remarkably low volatility.

TIPS, in general have many unique characteristics which were discussed in detail in Market Notes 3. Here are the key benefits:

1. If you buy a TIPS issue at a price of $100 or below and hold it to maturity you are guaranteed a positive absolute return.

2. If you buy a TIPS issue at $100 or below and hold it to maturity you are guaranteed a positive real return, or return above inflation.

3. The maturity value of a TIPS issue cannot be less than $100. This means not only do you own an inflation hedge but you also have a deflation option. In the event of deflation you would in effect own a bond that matures at $100. If this were to happen then a TIPS issue would start to trade like a fixed income bond at some point if inflation turned negative, and prices would rise.

In short you have a government guaranteed security that provides both a positive real return as well as a positive nominal return. This asset would also likely outperform almost all asset classes in the extreme cases of either high inflation or deflation.

An investment that is also a cash alternative

The new 5 year issues have the benefit of maximizing the imbedded option you own in a TIPS, while minimizing the price volatility of these assets.

For the new 5 year TIPS, the price volatility will be very low. There are three key reasons for this:

1. By definition their maturity is short and price volatility is low and falls very quickly.

2. Real yields are far less volatile than nominal yields.

3. The worst case for TIPS is rising real interest rates.  However, for TIPS priced at or below 100, inflation (whether rising or falling) always works as an offset to rising real interest rates. This further cushions their price volatility.

The third point requires some elaboration. First in the case of deflation the price of a TIPS, priced at or below 100, would rise, even if inflation was falling. This is because a TIPS becomes a type of fixed income government bond, all of which would rally if we experienced deflation, even if real interest rates were rising.

So TIPS, at or below 100, would only fall in price with rising real interest rates if inflation was positive or rising. In total return terms, therefore, rising inflation would cushion the blow from rising real interest rates. Indeed, the rise in real interest rates would need to be sufficiently large to offset inflation over the return period, in order to generate a negative return.

For all these reasons we can easily see that short maturity TIPS have very low volatility. Nevertheless, an investor can minimize risk even further. This can easily be achieved by buying a 10% allocation at each 6 monthly auction (often called a ladder). This would massively reduce risk further by spreading out the purchase levels and reducing overall volatility by around 50% compared to a new 5 year issue. Indeed a ladder constructed in this way would likely experience such low volatility that it could be considered as a high yielding inflation proofed alternative to a cash holding, with a deflation hedge, just in case! 

The bond market edge

 

Many investors lose out on a consistent basis by being invested in money market funds with very low returns, when with minimal risk they could substantially boost their returns in short maturity government bonds. Equally few seem to understand what a poor vehicle government bond mutual funds are. They should be avoided whenever possible as it is so much more attractive to invest directly in individual government bonds. With just a few simple steps it is easy to turn the bond market edge in your favour.

The table below shows a performance comparison between 5 year and 30 year government bonds. Over a 75 year period there is almost no difference in returns, even though a 30 year bond is far more risky as is shown by the difference in the standard deviation of returns. Why is this so? Look at the first column. The 5 year maturity consistently produces some capital appreciation, whereas the 30 year bond is just volatile with no bias. This factor is just as applicable to TIPS as it is to fixed income Treasuries.

How can the 5 year appreciate on a consistent basis while the 30 year does not? Well the 5 year and short maturities in general “roll down the yield curve”. The chart below shows that when a Treasury rolls down the curve, its market interest rate goes down therefore its price goes up. Short term maturity bonds therefore have an inbuilt return independent of their yield and market volatility. This is why on a risk/return basis the 5 year and short maturities in general usually have the advantage.

Avoid Government Bond Mutual Funds

Government bonds are very simple and they all carry the same level of very low credit risk. The only difference between them is their income level and maturity date. The level of income you choose will depend on your tax rate, so the only choice left after this is the maturity date.  

There are many advantages to owning individual bonds over government bond mutual funds:

1. With an individual bond you can choose the income level appropriate to your tax rate.

2. By choosing individual bonds you can select your buy and sale dates to lower your tax rate.

3. You avoid paying a management fee when you own an individual bond.

4. A mutual fund never matures whereas an individual bond does. An individual bond therefore has much less risk, particularly over long term holding periods and for shorter maturities.

5. By choosing an individual bond you can maximise the advantage of rolling down the yield curve.

Brokers and TIPS

You are unlikely to be informed of the extraordinary benefits of TIPS by most brokers. This is simply because investment in these securities involves almost no costs and very little or even no transactions. For the reasons described above government bond mutual funds are not popular and are therefore hard to sell. It is often not in a broker’s interest to inform you of what may be some of your best low risk, low cost options.

Although more than likely 5 year TIPS would form a low turnover part of your portfolio, bear in mind that there is an active secondary market in these securities and you can sell them any time any day (8.20am to 3.00pm). If you do go to the secondary market, take care who you use as a counterparty. Although, there is a very tight market and a good price for your TIPS some of the largest brokers often quote outrageous prices. Perhaps the best counterparty I have come across is Harrisdirect (I receive no benefit from recommending them), as not only do they provide up to date real time prices on their internet pages, but also good execution even in small amounts. Another alternative is to consider opening an account at Treasury Direct. You can actually have an account at the Treasury Department, although I have no experience of how well this works.

 

Conclusion

The introduction of the 5 year TIPS security should be a major event for investors. 5 year TIPS not only have the three key benefits all TIPS have, as described above, but they maximize the benefit of the imbedded option with extraordinary low volatility and asset safety. Indeed they are so safe that by constructing a ladder (spreading purchases over each semi-annual issue) you can construct a high yield alternative to cash that is hedged against both inflation and deflation.

Beyond this, 5 year TIPS also provide investors with the most attractive advantages of investing directly in bonds. These securities provide such a remarkable combination of risk/return benefits that used appropriately they can become an investment asset that is also a cash alternative!

Just as most houseowners have a mortgage. Most investors should have a portion of their portfolio in the new 5 year TIPS.

 

 

 

 

Notice

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Opinions expressed in these reports may change without prior notice. Chris Belchamber (the author) may or may not have investments or positions in any assets or derivatives cited above.

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