Bonds
Bond maven Bill Gross, manager of the world’s largest bond fund, Pimco Total Return Fund, laments the end of the long bull market in bonds in his latest commentary. He recommends bond investors make heavy use of TIPS, Treasury Inflation Protected Securities, whose yield is tied to the inflation rate. Gross’s argument is simple: with the significant reflation of the economy being engineered simultaneously by the federal government and the Federal Reserve, bond investors need to worry about protecting their principal value.
What I’m suggesting is that since the Fed sets the price of short-term money and that since other yields are significantly influenced by today’s 1% Fed Funds mark, that there’s not much a bondholder can do. First of all, yields are extremely low on an inflation-adjusted basis. In addition, bond prices and therefore total returns are at risk if reflation takes hold or – heaven forbid, if foreign creditors begin to unload their sizeable holdings. And, of course, sitting out the dance by staying in money market funds earns you that confiscatory negative real interest rate. What, poor babies, are we bondholders to make of all this?
The way to attack this seemingly hopeless conundrum is by holding TIPS – Treasury Inflation Protected Securities. At first blush this solution seems obvious. If the government is bound and determined to reflate the economy and inflate bondholders down the river, then something with “inflation protected” in its name seems a reasonable bet. These TIPS, as almost all of you know, match the CPI one for one, three for three, or ten for ten. Whatever inflation is, you get compensated for it plus a permanent coupon to boot. These bonds with varying maturities and varying coupons today yield 1% “real” for the shortest maturities and 2.8% “real” for the 30-year TIP. That is, whatever future inflation is, you get that return plus the real yield. Does this beat the negative real rates on money market securities? By a landslide. Does that real return protect you against the reflationary erosion of your principal? Of course. Does that mean you can buy these things, stuff them in your mental vault, and sleep soundly at night? Probably – but not quite. Their prices do go up and down as “real” interest rates change so that over time periods less than the stated maturity, you could be looking at a “book” loss.
But having said that, the door becomes wide open for the third and final kicker in this bond àge à trois. First, TIPS beat the onus currently imposed by the Fed via negative real short-term interest rates. Second they compensate the holder for future changes in the CPI thus avoiding the reflationary intentions of Greenspan himself. And third, TIPS are one of the few fixed income sectors that actually stand a chance of appreciating in price as the Fed attempts to reflate. The key to this third potential kicker lies with history and the understanding that real interest rates in an average (or even reflationary) economy have been much lower than current existing levels. The current real rate for the 30-year TIP at 2.8% and the real rate of 2.25% for the 10-year TIP are slightly above historical norms. Thus they have the potential to appreciate in price if real yields fall in future months and years. . .
The Fed and the U.S. government are attempting to reflate the U.S. economy in order to relieve the deflationary burden of excessive debt. Politicians do this via deficit spending. Fed governors do it by enforcing low/negative real short-term rates that strip savers and bondholders of their wealth and then erode long-term bond prices through the effects of higher inflation. You/we can fight back. By some egregious folly, the Treasury began to offer a safety valve back in 1997. They began to issue TIPS. These securities won’t make you rich, but they’ll protect your principal in the ensuing years and even stand a chance of going up in price over the near term. Buy all you can.
