Must Pick and Choose to Find Value in the TIPS Market

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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Now I don't expect 8% in 2011, but that said, the fact is the first three months of 2011 are going to generate two percentage points of inflation. And TIPS, as you know, their value goes up one-for-one with inflation. So, you buy TIPS for $100, and after three months they'll be worth $102, because you'll accrue these two percentage points of inflation.

So where we're investing a lot of our clients' assets in our TIPS portfolios is at the very front-end of the TIPS curve, in the six-month securities and the one-year securities. The reason for that is you pick up all of this inflation accrual, moreover you're basically insured against a Fed hike. We think the Fed is very unlikely to hike in 2011.

Although the direction of Fed policy moves is undoubtedly higher--starting from zero, there's only one way they can go, we don't think they're going to move for 2011 for the next six to nine months. So, parking your cash in the very front end of the TIPS curve, in the six-month TIPS and the nine-month TIPS, is a very attractive way to earn this high inflation accrual and yet be protected against perceptions of Fed hikes.

Jacobson: So, if I understand correctly then, the overall rate sensitivity of the portfolio is a bit short compared with the benchmarks that you're used to, right?

Worah: Correct. So, we are underweight TIPS. So, our rate sensitivity is short to the extent that we expect that interest rates are likely to rise, whether it's the Fed hiking rates sometime in 2012 or the market anticipating a higher neutral five and 10-year rate given our growth expectations, or the market forcing a higher rate on U.S. Treasuries based on a long-term fiscal deficit.

For all of these reasons, we expect interest rates to be rising throughout 2011 and 2012, and we've positioned the portfolio to not get hurt by higher interest rates by being underweight or short duration relative to a passive TIPS benchmark.

Jacobson: So, just for the benefit of our Morningstar clients and viewers who are not as comfortable with TIPS as maybe they'd like to be, and putting into context, of course, the fact of what you just said, which is that you're working pretty hard to insulate the portfolio from that sort of rising yield concern.

Can you help paint a little bit of a picture for us as to why, let's just say for the sake of argument, you were talking about a benchmark-like portfolio, why that kind of portfolio of TIPS in particular, would have risk insensitivity to rising yields--and I say that, of course, in the context of a lot of people mistakenly thinking that inflation protection means protection from rising yields, which it doesn't?

Worah: Right. So, that's a great point. So, TIPS although they give you inflation protection, TIPS prices and TIPS valuations depend on two factors. One is the inflation, and we've talked about as inflation rises, the value of TIPS rises one-for-one with inflation. So, you buy TIPS for $100, inflation is 3%; your TIPS are worth $103. But the second factor that goes into TIPS valuation is that they are fixed-income bonds at the end of the day. This is real interest rate aspect of TIPS.

Today, the real interest rate on five-year TIPS is negative 50 basis points. To the extent that one-year from today, you find that the five-year real interest rate in the U.S. is positive 50 basis points, you'll have taken a loss of about three percentage points. So it will cancel out all of your inflation accrual.

So what that says is, in an era of rising interest rates and rising inflation, TIPS are certainly a better security to have than almost any other fixed-income asset, because the rising inflation--the rising value due to rising inflation will cancel out some of the drop in value due to rising interest rates. But that said, we must remember that there are two factors that affect TIPS pricing--not just inflation, interest also go into valuations, and rising interest rates lead to lower prices for TIPS.

Jacobson: Just to put that another way, I think it sounds like it's fair to say the way you're describing it that even if yields rise over a period of time, the idea is you've got that inflation protection over that time period kind of catching up, even though you might have a lot of volatility in between with rates bouncing around and going up. The idea being, though, that if inflation is really pushing itself up far enough that will eventually cancel out some of that risk.

Worah: That will cancel out some of that risk, and for that reason in the fund, in particular or at PIMCO in general, out of all fixed-income securities, we certainly like TIPS the best, because at least they have the inflation-accrual component of it, which guarantees you that rising interest rates alone will not negate or will not completely erode the value of your investment. Rising inflation can negate some of that.

Jacobson: Great. Thank you so much. We appreciate you taking the time and talk with us.

Worah: Thanks, Eric always a pleasure to talk to you.