So I’m trying to figure out where to put my cash in my InteractiveBrokers account, since there is no money market sweep and it might as well be earning a little, and I decide to buy a TIPS ETF (you might remember my post a few weeks back). This seems sensible… it looks like the Fed is cutting interest rates to stave off recession, but there is still a reasonable chance of inflation/stagflation. So if rates go down, the bond value should rise, and if inflation ticks up, the inflation protection portion kicks in. So I buy TIP. It tracks the Lehman TIPS index, with a duration in the area of 1-2. It’s issued by BGI, even though what it tracks is a Lehman index, so Lehman’s problems shouldn’t impact it so much. Yet, a few weeks later, it’s down about 2.5%. Not exactly a good cash substitute after all, especially after a 75bp rate cut (admittedly this might already have been priced in). On the charts, it looks like I bought at the top. I’m just curious, I can deal with the loss, and if it’s just trading noise, I can ride it out, but I’m not sure I understand why it’s doing this and whether I have appropriately understood the risks here, and whether something else is happening. Can anyone help me out? If TIP isn’t good, what might be another place to park idle cash for more than 0%. Admittedly it’s not a substantial sum, which is why I went for an ETF rather than going and buying a single TIPS bond (that and more familiarity with purchasing stocks/etfs).
This may be a dumb question, but is the expected gain greater than the two commission charges? I place my idle cash in a direct bank. They still pay ~3.0+% APY with no minimum balances. INGdirect even gives new customers $25 free for signing up. BankRate.com gives an overview of money market yields available if you are not opposed to opening a new account at an institution.
I would be SHOCKED if the lehman tips index is a 1.5yr duration. I would guess closer to 5-6.
My bad, Grover, I rechecked and you’re right, the duration is about 6.75. I could have sworn that I saw the discussion of using maturities of 1-3 years when I investigated, but it’s not true. But this makes me more puzzled. With that kind of duration, the drop should be even less understandable. I am just thinking through whether this is just supply/demand fluctuation as people shift things around, and whether an ETF is really a sensible approach to a cash substitute.
Did you buy TIPS two weeks or something? You just grabbed the falling knife (the yield curve in this case). TIPS were returning a negative real yield. Did you expect that would continue if the world didn’t fall apart?
Hmm… never thought about it as a falling knife, but yes, it was about two weeks ago. How do TIPS return a negative real yield (unless the gov’t messes with the inflation figures). I thought that the inflation indexing was supposed to account for that? In any case, I still expect the world to continue to fall apart, after a short breather. And even if the Fedster pumps more and more cash to bail out firms, that’s got to come back and bite us in the inflation butt at some point. So right now I’m still holding TIPS, just wondering if that decline should make me rethink things.
Did you check the yield? Hopefully that cushions the downside. My hopes at least.
They had a negative nominal yield, but they will always provide a positive real return.
SHY is more like cash. When you’re too shy to buy stocks then buy shy. Move you cash to fido right now. I normally use them for my basic banking services but the returns I’m getting on muni bonds are off the chart… I’m averaging 8% tax free. I can liquidate the bonds on a weekly basis. If ever I cannot liquidate then I get the penalty rate of 12-15%. So… that’s fine if that happens! I am bidding on a washington d.c. general obligation bond that is secured by property taxes and paid the penalty rate last week. Call me crazy…
It’s just a question of timing really. TIPS are very sensitive to oil and other commodities, and since your purchase we’ve seen the CRB index fall about 8% from its highs, crude down about the same, and some pretty big sell offs in base / precious metals as well. The better than expected CPI print didn’t help your cause either. I agree with your thesis but this is a crowded trade and you are fairly late to the party, unfortunately. The Fed cut was pretty well expected (in fact the futures market had been pricing in 100bps), and last week the flight-to-quality bid evaporated a bit in the treasury market in the Jamie Dimon is our lord and savior euphoria. Plus, FOMC actions are more relevant to the front end of the treasury curve, the 10yr is right around where it was two weeks ago. So you haven’t enjoyed much of a rally in nominals at all, while inflation expectations have come down. My advice is to think about TIPS in terms of breakeven yields (nominal treasury yield – matched maturity TIPS yield). This is the inflation rate being priced in by the market over the life of the bonds. If you think inflation will come in higher than the breakeven, you are better off in TIPs. If not, you’re better off in vanilla treasuries. One way or another though, an ETF like this is a total return product, you are exposed to market value fluctuations. Depending on your holding period a shorter duration product might be more appropriate.
Well put nodge. Looking at breakevens is key, though some opine that forward breakevens are a more accurate assessment of inflation expectations, but we’ll leave that to the academics. I would add to nakedputs that the yield on TIPS is, by definition, real. There is no nominal component. Nominal US Treasuries have a nominal component. When TIPS yield 3% that is 3% above the rate of inflation. When they yield -90 bp, that is 90 bp less than the rate of inflation, so a negative real yield. TIPS have an assumed rate of inflation determined by the all urban consumer portion of CPI. So, this adjusts principal. When they yield zero, you receive this adjusted return and nothing more. If you believe that CPI will rise above this assumed inflation rate (adding to positive carry), then a negative real yield can then still be a value to you if principal adjusts higher such that you receive a higher coupon payment (coupons stay constant, but the payment adjusts with principal). So, buying negative real yields is not a be-all end-all statement of return. It depends on your view of inflation relative to what is assumed in the bond over its maturity. At least, that is my understanding. If someone is more active in this market than I and wants to add or correct, please do.
The increase in principal value is not yield. They have a negative nominal yield in the 09 and 10 series because real rates during this period are expected to be negative. They will still offer a positive real return (not yield) during this period.
The increase in principal multiplied by the static coupon is how they keep up with the stated inflation rate - that is in fact the mechanics of the instrument. You are also taxed on this increase in principal, which is “phantom income.” If we can agree that a real yield is the yield on an instrument less the rate of inflation, then the nominal yield on a 2yr note (non TIPS, the 2s of 2/10) is 1.793%. This is a negative real yield of, say -2.207% (using the most recent y/y CPI data @ 4%). An equivalent TIPS is 15 bp real yield (0.875 4/10 - ie, at par, these will provide a 7/8% yield to maturity, which is a real yield). This is from PIMCO in 2003 (so the data is not accurate for today’s market, but the point is the same)… “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.” Gross is saying that you are paid for inflation plus a real yield. When this real yield goes negative, you are, mathematically earning inflation less something (the market based yield - which is a function of price, a static coupon, and principal adjusting higher based on an assumed inflation rate). You are inherently earning less than inflation. I’m not sure to be honest whether your total return would be positive if you bought the TIPS 3.875 1/09 @ 103-4 right now (yield is -38 bp), considering amortization of the premium. If so, then yes, you will get a positive return, but it will not be a positive real return, given the negative number. Here is a marketwatch article: http://www.marketwatch.com/news/story/inflation-fear-factor-drives-investors/story.aspx?guid={31407552-6802-448D-BBE3-87A204BBAAEB} Some guy’s report on them: http://www.larkresearch.com/tips.htm
This is from a Lehman article, which also states that real yeilds as of this publication (5/1998) have been as low as zero (now negative)… maybe I am misunderstanding this debate… The History of Real Short Rates The real short rate is defined as the difference between the nominal short rate and expected instantaneous inflation. We approximate market inflation expectations by a 12-month moving average of CPI changes and use the 3-month general collateral repurchase rate as a measure of the nominal riskless short rate. Figure 1 shows the daily history of nominal and real short rates for January 2, 1987-February 27, 1998. Real rates have been as high as almost 6% and as low as 0%; the historical average for the period is 2.5%. Although the real short rate has remained far from its average for extended periods of time, it has consistently reverted. The historical half-life of the short rate, a measure of the speed with which the short rate reverts to its long-horizon average, is 1.07 years. The historical average short rate volatility is 156 bp per year though recent volatility has been much lower. Recently, the real rate has risen sharply to a level around 4%. This increase was caused by a combination of a relatively constant nominal rate and falling inflation expectations. The historically high real short rate has been accompanied by an inverted real term structure.
Virgin, I may take your advice and move part of the cash allocation to SHY. However, I want that money available as dry powder for my IB account. Fido/Fidelity’s transaction costs are a little rich for my taste, even though I think I am relatively low turnover. (I remember you mentioning SHY in my earlier thread on cash, so now that I see TIP has a duration on the order of 6 or 7, I definitely want something that is low duration)
Fidelity has research from lehman that is pretty good. Also, free bill pay & atm. Their fixed income products are great. I believe they’re worth it as far as brokers go. I have most of my $$$ in IB cuz it’s so cheap. I forgot… if you go into FIDO and open an account you get a bunch of frequent flyer miles (depending on the amount of $$).
Interesting. I’ll think about it later. How about SHV for cash instead of SHY? This appears to be an ETF of Treasury securities with between 1 and 12 months of maturity remaining. SHY uses maturities of 1-3 years. Seems that interest rate risk is pretty low there with SHV (even more so than SHY), and the fluctuations in price appear to be consistent with fairly steady growth plus ex-dividend adjustments. — Big Nodge, your point about oil made the most sense to me in terms of the TIPS reaction. With oil prices down, people must be thinking that inflation is not a big worry after all, hence TIPS become less attractive, thanks.
Bchadwick, as Nodge points out, it is also a bit of a relative value trade. As inflation expectations are priced into or out of the market, the breakeven spread will widen or narrow. As oil comes off, it could (at the margin) force TIPS to underperform nominals (all things equal). But it could also indicate lower tax on consumer, etc, etc, which would be a bearish (probably flattener) in nominal USTs. It is a relative value thing. If inflation expectations come off, TIPS could still decline in yield but it is likely that nominal yields decline further, outperforming them. Imagine an inflationary environment with a flight to quality - I can guarantee that both nominals and TIPS rally. Which is performing better? What is that spread doing? That will give you an indication of the market’s expectation toward broad prices.