Monday, May 25, 2009

Treasury Inflation Protected Securities as a Non-Correlated Asset

added 6/3 & 7/2009: A few more recent discussions of the TIP are in these later posts:




I also have a Gateway Post that collects links to all of my discussions on Bond ETFs:

*************original post:


Before starting this discussion, I would like to link a chart that shows correlations among various asset classes.


I currently own TIP, an ETF containing U.S. Treasury Inflation Protected securities, with a very modest .2% expense ratio. iShares Barclays TIPS Bond Fund (TIP): Overview State Street also has an ETF with these securities in it, IPE, with a .18% expense ratio. SPDR Barclays Capital TIPS ETF The TIP has a high positive correlation with U.S. bonds. 

So, if I am seeking an asset to diversify my U.S. bond assets, this would not be my choice. For that, I would look at international bond ETFs like WIP and BWX, and emerging market bonds. The TIP can have a strong negative correlation with U.S. stocks, particularly during a stock bear market, which is why it has a place in an asset allocation. The negative correlation varies according to the particular stock category, and time period, with one author noting wide swings over longer periods of time including some periods with positive correlation. (p. 163: Google Book Search)



(I just ordered that book from Amazon, authored by David Durst. I want to know more myself about non-correlated assets.) I would not be surprised by the strong negative correlation between the TIP and stocks over the past year given the direction stocks have taken particularly since September 2008.

In a static asset allocation approach, an asset like TIP would remain in the allocation, never eliminated, and possibly trimmed some in periodic rebalancings (Rebalancing (investment) and possibly given more weight in the allocation as the individual ages.

What I am about to say is worse than sacrilege among static allocation enthusiasts. I will at times eliminate the TIP entirely from my portfolio based on a number of considerations, and then add it back when the market is pricing the inflation protection inappropriately in my view. This would be called foolish by practitioners of static allocation, and is only for those individuals with a lot of free time on their hands. It probably helps to have a mind set that efficient market theory is garbage.

I have eliminated TIP entirely, with the last elimination occurring last year when it rose to around 105-106. At the time, I thought the price for the inflation protection was too high, which results in the spread in yield between the TIP and the comparable fixed rate treasury becoming too large in my opinion. 

As it turned out, the large spread soon evaporated, and the two securities narrowed to almost an identical yield. The market made a mistake on both occasions. As that spread starts to widen, I would expect the TIP to be rising in value compared to the fixed rate coupon treasury. This is a link to a web site with a good explanation in both written and video form with some charts too. Inflation with the TIPS Spread | Intermarket Analysis | Stocks


Then, when the spread narrows to a point when I am paying virtually nothing for the inflation protection, I will consider buying the TIP back, since I am generally not willing to assume that deflation will be norm for very long and that is what a non-existent spread is basically forecasting for an extended period of time, at least when the TIP and the comparable treasury are both 10 year maturities. This narrowing happened in the 4th quarter of 2008, and I was then buying the TIP back in the low 90s. TREASURY INFLATION PROTECTED BONDS (TIP)

My prior discussions of the TIP are linked under the category TIP in this Gateway Post: Bond ETFs: Links in One Post

This movement in and out of TIP may not occur again for months or even years. It really requires me to exercise some judgment about whether the market has swung too far in one direction or another when pricing the TIP. I would understand an "expert's" criticism of an individual investor trying to make those sort of judgments. I would even echo those criticisms for most individuals who do not have the time and experience to form judgments about such matters. But, LB is 1/2 trader and it has to give it a go-so far so good on the TIP.

Another problem with the TIP is that both it and the comparable maturity fixed coupon treasury both may be priced incorrectly on their base yields (e.g. assume both have a base of 2% and the fixed coupon has a 1% advantage over the TIP over that base rate (REAL YIELD), is that reasonable under the market conditions then existing or should both have a higher base with at least a 2% inflation expectation built into the TIP price). I am concerned about that issue right now. This is how I summed up the problem in a prior post:


"One of the negative points that I made about TIP is that it will be adversely impacted when comparable non-inflation treasuries take a hit. The TIP may not have much of a premium to non-inflation protected securities but the yield on both may be out of line (i.e. what happens to a TIP if the comparable treasury moves from a 2% to a 5% yield?). TIP pricing The ETF TLT (20 year treasury) is down 2.16% in early trading and the TIP is down 1% and the 7 to 10 year treasury ETF has fallen .63% in early trading. IEF 

This is just my opinion but I believe TIP can go down when the comparable treasuries rise in yield since the basic yield of both securities may be too low. Thus, I just look at TIP at the current prices being more favorable to own than the comparable treasuries without any inflation protection. If I had to choose one over the other I would pick TIP. This does not mean that either will be good investments at the current prices when and if treasuries as an asset class start to fall in price and rise in yield. MORE ON TIP PRICING

See also,  TIP pricing

So I might trim TIP when I develop a strong opinion that both the TIP and the comparable treasury are priced to yield too low. That will be far more difficult than making a judgment on the spread being too great or narrow. I can look at a chart and make a good "guess" on that later issue. For now, I am just open to making small adds to TIP, maybe in 30 share increments, though I have not even done that this year yet. Basically, I am not enthusiastic one way or the other.

I am not particularly enthused about any of the bond ETFs now, due to their low yields. The Vanguard Total Bond Market ETF ( BND) is hovering around 4%. 

The international bond ETFs that I currently own have lower yields. I have lived through enough interest rate cycles to know that a 4% yield can get wiped out pretty quick in the devaluation of a bond's price, when bonds start to fall in value based on a change in inflation expectations or the actual rate of inflation. 

 I am not one to assume that the current bull run in bonds is going to run for several more years. I am in a month to month evaluation of a potential shift from a bull to a bear market in bonds. The current time may easily turn out to be an inopportune time for new purchases of bonds at such historically low yields and high prices. 

In Dynamic Asset Allocation, I have to be mindful of what is happening in the market and in the real world.David Swenson's comments on Inflation/ TIP-WIP-Floaters/ how will the dollar react?/Summers-Tarp-Bank stocks/alcoa 

Consequently, I have already eliminated BND, BSV, GVI, and SHY from my portfolio. I am in an active management mode on BWX. I have already re-allocated money raised from the bond ETF sales into floating rate securities and higher yielding corporate debt, bought mostly on an opportunistic basis. The point is simply this. TIP has a place but not a permanent place in my application of Dynamic Asset Allocation for an experienced individual investor managing his own portfolio and solely responsible for every decision made. All individual investors need to recognize that personal responsibility for their own decisions, and prepare to make them with that attitude in mind.

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