Arijit Dutta: Mihir, you've said elsewhere that TIPS are great hedging tools in this "new normal" economic and financial setting that we are in. Can you expand a little bit for our viewers on what the benefits of TIPS are at this time?
Mihir Worah: Sure. At PIMCO, what we call the "new normal" is essentially a regime of possibly low growth, high regulation, and high volatility in economic and financial variables.
And what you might find is that old relations that you could depend upon no longer hold in this new normal. And so the one big plus for TIPS in an inflation hedging program, is the fact that by contract they're one-for-one tied to the CPI index. TIPS prices or TIPS values will move one-for-one with what inflation does, no matter what volatility regime you're in.
And what happens is, in this new normal, as relationships break down, there are certain relationships that people believed, held, that equities would be a good hedge for inflation, real estate would be a good hedge for inflation. And clearly there are times when this might hold, for example, if you have modest inflation, it's likely that equity prices go up with modest inflation. Realistic prices go up.
However, one of the factors of the new normal is going to be the unpredictability, the volatility. Right now the market is grappling between deflation and hyper-inflation. If you have hyper-inflation, certainly equity prices are not going to do well. But TIPS prices will still go up one-for one.
And recently we've seen the breakdown between housing prices and inflation. And real estate equities, to the extent that these are pseudo real assets that help you to hedge inflation, a large factor is at what time in the cycle you buy these assets. While TIPS you don't care. Wherever you buy them, they will move one-for-one for inflation.
So what is the biggest advantage to TIPS--and people are realizing that--is it is the only explicit inflation hedge. There are implicit hedges; commodities we talked about as an implicit inflation hedge. But TIPS are the only one that is explicitly tied to inflation.
Dutta: OK. So as far as strategy in your fund goes, what are some of the key things to remember when managing a TIPS portfolio at this time?
Worah: Sure. That's a great point. Clearly the one thing to remember is the volatility that we're likely to see out there. That's one of the overarching features. So be defensive, be nimble, and if the facts change, change your mind. Don't be tied to any one dogma.
That's what we try to practice at PIMCO. We're constantly analyzing the facts, and we take a view in our portfolios as active managers, based on our best reading of the economy. But if the facts change, we change our minds.
I think the one thing that TIPS investors should be aware of--it's fairly critical--is that all the TIPS prices go up and down with changes in inflation because they're contractually tied to inflation. TIPS are fixed income securities, and the prices also change with yields in the market.
And I just wanted to bring this out, because you're probably aware that a lot of investors don't quite understand TIPS. When they buy TIPS, they're thinking they're buying inflation protection. While they're buying inflation protection, there's also a yield component to it.
And to the extent that in the foreseeable future we expect real yields, which is what TIPS prices react to, to stay low because the economy is in a low growth phase, the policymakers--the central bank--is going to keep policy stimulative and keep real interest rates low to try and get the economy back on track, TIPS are not going to take capital losses. TIPS will do well on the interest rate side.
However, once the economy heals, you will continue to get the inflation protection from TIPS, but you could see TIPS prices reacting adversely as interest rates rise. That's nowhere on the near horizon, but that's something that investors need to be aware of.
Dutta: Thank you so much, Mihir.