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By Eric Jacobson | 04-11-2011 05:21 PM

Must Pick and Choose to Find Value in the TIPS Market

Six-month and one-year TIPS along with 30-year TIPS look more attractively priced than five-year TIPS, says PIMCO's Mihir Worah.

Eric Jacobson, our director of fixed-income research, recently visited PIMCO's offices and sat down with Mihir Worah to learn about what PIMCO is doing in their Real Return portfolios today.

Eric Jacobson: So, Mihir thank you so much for joining us today. I appreciate it.

Mihir Worah: It's my pleasure--always a pleasure to talk to you, Eric.

Jacobson: We want to obviously get into understanding a little bit about what you are doing in the Real Return portfolios, but perhaps, it would be a good place to start to just sort of recap PIMCO's overall thinking on the government bond markets and go from there?

Worah: Sure. So, our basic premise is that most sectors of the government U.S. Treasury bond market are overpriced. Just to put it rather simply, if you look at five-year Treasuries yielding around 2% today, and if you think inflation over the next five years is going to be around 2.5%, so, then investing in five-year Treasuries means, you earn negative 0.5% after inflation.

We don't think that's a reasonable rate of return on a Treasury bond in an economy that's not in deflation or not in a depression. So, Treasuries are rich and unfortunately, by association, because TIPS happen to be Treasuries, too. certain sectors of the TIPS market or the TIPS curve are rich as well. So, you really have to pick and choose and find value in the TIPS market today.

Jacobson: I know from having talked to you that even though you are pretty negative on the TIPS market on a valuation basis, as you just described, you still need to own TIPS not just because it's the mandate, but because of what we'll call carry reasons, which hopefully, you can try to explain what that means and how is it expressing itself in your portfolios?

Worah: Sure. So, for one thing, even though I think tactically or temporarily TIPS are overpriced right now, they certainly have a part in anyone's inflation-hedging portfolio, because you could get surprises, you could get supply shocks coming out of the Middle East, oil prices going up, and then TIPS will certainly be the hedge that protect you against higher inflation.

That said, certain sectors of the TIPS market, like the five-year sector we talked about, are overpriced. Five-year TIPS today give you inflation minus 50 basis points. The real rate on five-year TIPS is negative 50 basis points. So, you're guaranteed to get inflation minus 50.

That said there is still value in sectors of the TIPS markets. One sector that I will touched upon very briefly is 30-year TIPS. 30-year TIPS return you inflation plus about 2%. We think those are appropriately priced.

Moving, and like you said, based on the very near-term inflation outlook, another very attractive set of the TIPS market is the very front-end; six-month TIPS, one-year TIPS. For the first three months of 2011, we are going to get about 2% of inflation non-annualized. In January, February, and March we're going to get two percentage points of inflation. If you annualize that, that's 8% inflation rate annualized.

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