Treasury Inflation-Protected Securities

TIPS (Treasury Inflation-Protected Securities) are much in the news these days and also in the hearts of many investors. Is this the right approach? That depends. If you are looking at TIPS as a long-term hedge against inflation, then TIPS make a lot of sense, nearly all the time. As a tactical move, in anticipation of nearby inflation, we’re not so sure.

Let’s take a step back and look at TIPS before we go forward. TIPS, or Treasury Inflation-Protected Securities, are Treasury bonds that are indexed to inflation and have their principal value adjusted upwards when inflation deflates the real value of the investment. So, TIPS are pro-inflation investments. As one might guess, TIPS don’t have the same current coupon as traditional or straight bonds. Since much of the coupon on straight bonds is a payment for accepting inflation risk, the coupon on TIPS wouldn’t need that part. Since TIPS were first floated in the 1990s, the spread between TIPS and straights, essentially the inflation forecast, has wavered between as little as 1% and nearly 4%. Currently it is about 2%.

The strategy when buying TIPS is to anticipate rises in inflation beyond the expected inflation imbedded in the current guess. Now would seem like the time for that strategy. But, wait. There is a second element, time. Recently, inflation has been rather meek. It may yet be a while (probably quarters as opposed to months) before the inflation in the pipeline gets out into consumer prices. During that whole time, you are accepting the trivial coupon from TIPS instead of the not quite so trivial coupon from some other bonds.

Another aspect in the equation is the price. Ever since the inflation scare began several months ago, the price of TIPS has been inflated simply because there are a lot more buyers than sellers in the marketplace. Since most people buy their TIPS either directly from the Treasury or by buying a mutual fund of TIPS, there hasn’t been a lot of room for market participants to arbitrage the excess price action away. The mutual funds just want to stay fully invested and don’t really much care what price they pay. Individuals buying direct from the Treasury pay what they must to get the bonds. So the inflation guess imbedded in TIPS today is far too low. Said another way, the price is far too high.

Today is not a great day to buy TIPS. It may be a good day if inflation comes roaring back a lot sooner than we think or if you are a patient investor who just wants inflation protection regardless of the price. But, if you are performance sensitive, today is not a great day to buy TIPS.

Our guess is that we can still reap some benefit from one of the several other options in bondland before TIPS become really timely again. If we can achieve better returns somewhere else (currently that would be GNMAs and high grade corporate bonds) and then swap into TIPS when inflation is actually about to break on us, that would be optimal. That timing does leave us with one very important element, when. The current guess for that would be mid- to late next year, but that is subject to all sorts of adjustment.

TIPS are the ultimate in defensive bond positions. Even cash doesn’t give you the same protection against inflation that TIPS give. But, now is still the time to be offensive in bonds as spreads across most sectors are still at historically wide levels. As those spreads continue to tighten we will earn outsized returns (for bonds at least).

September Song

September is the worst month of the year for stock returns historically. (And yes, we switched gears with hardly a warning of the change. Try and stay with the program.) Why do you suppose that is? Your punditry team has a couple of ideas about that. First of all, by September, the calendar is starting to get a little worn-out. There isn’t a lot of year left. So, all those optimistic forecasts from January are starting to look a little stale. Reality bites. So, by September the forecasts have to acknowledge that all the growth you used to be expecting will transpire some other time and not right away. This year is getting ready for the history books and next year all the wonderful things are going to happen that didn’t happen this year. So, the bad news comes out now about what is really going on this year.

The second issue that plagues September is election years. Every other year we have massive election fever transpiring in America. Every other of those years gets really bad with Presidential elections on top of the Congressional (the opposite of progressional?) elections. To get elected, there are two strategies: if you are trying to hold onto your seat, you claim that all the good stuff that has happened is because you are occupying that seat; if you are trying to get elected, you claim that everything is awful and that only electing you with change that. So, we get this divided picture of America that things are great or awful. The awful part is new and so it shakes our confidence somewhat. Combine that with the calendar issues above and it is no surprise that we wonder if our long-term investment plan is correct.

Well, that’s our view on it, or at least a couple of the views that are fit to print.

Economic News (we’ve discontinued the Good News section since most of the economic news seems to be good news these days)

The ISM-Manufacturing index rose above the 50 mark for the first time in 19 months. Numbers above 50 indicate expansion in this diffusion index. The actual number not only rose above 50, it jumped to 52.9. That would be the highest reading in well over two years. This also means this index has risen 20 points from the cyclical low of 32.9 last December. All that said, the US economy is not all that dependant on manufacturing for its wellbeing. Manufacturing makes up a smaller chunk of overall GDP than services, so the report later in the week on services was more meaningful for the outlook.

The ISM non-manufacturing or services index rose in August to 48.4% from 46.4% in July. The improvement was about what economists had expected, but with the rise in the manufacturing gauge to above 50% there was a hope that services would breach the 50% barrier as well, so, good news but mildly disappointing none the less.

Factory orders rose 1.3% in July. The gain was less than expected but still positive. Orders have risen for four months in a row and are one more bit of evidence that the economy is on the mend. This is also one of the leading economic indicators that have been signaling improvement for a few months now.

The Bureau of Labor Statistics announced that the US economy lost only -216,000 jobs in August. That is the lowest number of job losses in a year. But, the key is that it was still an improvement from the over -700,000 by in the spring. If we trend the numbers since February, it looks like we’ll have increasing jobs by November or December. But, as our old statistics professor was fond of saying “don’t follow a trend-line out a window.”

One interesting element in this latest jobs report is that the government sector actually lost jobs. This also happened in July’s report. The government sector seldom losses jobs. So what is behind the government job losses? Is this some statistical fluke or are these job losses real? Your pundit doesn’t know. These are not rhetorical questions. Our guess is that state and local governments are purging employees due to budget constraints. But, that isn’t a documented explanation.

The unemployment rate rose to 9.7%. This too was something of a surprise. Last month, with a larger number of job losses the unemployment rate actually fell. Maybe there was a rounding error in there along with a larger employment pool for some reason. Remember the unemployment rate is derived from the household survey and is largely independent of the establishment survey that determines the jobs number above.

Wage rates rose by 0.3% in a sign that workers who have jobs are getting paid somewhat better. Hours worked in the economy also rose so that same pool of workers is spending more time on the job each week. As these things usually go, hours start to climb and then slowly, workers are added back. You just don’t get increased employment unless it is the cheaper option than making the current work force toil a little harder.

Weekly Stuff

Okay, for the month-end shortened week from last Tuesday through Friday, the markets did hardly anything at all. The big drop last Tuesday was pretty much wiped-out by Friday. The dire warnings about September seemed so believable after last Tuesday, but now they seem a little less scary. Be of good cheer and think positive thoughts. It won’t really help, but you’ll feel better for being proactive.

The US market wiggled around a lot but ended about where it started. The same could be said for the developed international world. It was only the emerging markets that made any headway at all. China got back into drive after being wracked by fears the government might take away some of the ample credit that has helped damp the impact of the global recession on China. The ample credit has fueled a commercial building boom in the outward looking coastal provinces. Take away the credit and the whole thing could grind to a halt. But, the Bank of China has told everyone who would listen that they understand the situation and they will sustain the economy until the rest of the world rights itself.

Most bond markets around the world did hardly anything. With the G20 finance ministers meeting in London over the weekend and the heads of state getting together in Pittsburgh in a couple of weeks, there was a lot of rumor and not much fact to trade on, best to keep your book square and not go out on a limb that some politician might just saw-off. The finance ministers talked about how and when to end the huge support they have provided to the markets and their respective economies. The so-called ‘exit strategy’ is all the rage these days. It took these politicians months to figure out that they all have pushed a huge amount of money into the system and all their efforts are going to be undone if a huge wave of inflation eats up all the stimulus. Good luck boys!

The real estate market slipped on further fears that the deflation in commercial real estate prices hasn’t gone far enough. The FDIC commented that commercial real estate was an area that they were afraid would cause more trouble for banks as defaults on commercial mortgages were rising. But, most REITs own their properties outright or lever them only modestly. Plus, many of the most levered REITs have managed to either raise cash through equity offerings, debt refinancings or sales of properties and so there are few public companies with any serious debt overhang at the present. Though commercial real estate might still cause a problem for banks, it is not likely to cause serious problems for the publicly traded REITs.

Lastly, commodities had a tough week. First, energy prices fell (though you couldn’t tell from the prices at the gas pump over the long holiday weekend) and natural gas was especially hard hit. Other commodities followed suit including the industrial metals and some agricultural prices.

Au revoir 

This is happy new year again for the business world. With the summer vacation season now over and the kiddies back in school, it is time to get back to work. It is also about time to start thinking about 2010 in a much different way than we have up until now. In many big corporations the budgeting process for 2010 will start right about now. The CFO will be sending out memos to his minions to prepare documents showing where this year’s budget is versus plan and where we can cut next year. The big division heads will be getting an update on where they stand and their lieutenants will get a pep talk about budgeting in the next couple of weeks. There will be meetings galore all across corporate America specifically about this. 2009 is just about over and 2010 is about to begin.

The market will soon dispense with worrying about 2009 and start the dreaming about 2010. At this stage, just about anything can happen next year. Some tiny biotech can cure cancer or acne and become the next Bayer. Any retailer can become next years Aeropostiale. Your dog of an insurance company can finally deliver on the promise of their balance sheet. Yes, anything can happen and it will take about a year to come to the conclusion that it probably won’t. But, from the vantage point of now, all these things are still possibilities.

Have a really great week!


Karl Schroeder, RFC

Investment Advisor Representative

Schroeder Financial Services, Inc.