Treasury Inflation Protected Securities (TIPS) are more attractively priced than ordinary Treasuries of the same maturity.

About Ordinary Treasuries

Ordinary Treasuries pay a fixed amount of interest twice per year and mature at a fixed principal amount.  Treasury interest for US-persons is exempt from State and local income taxes, but not Federal income taxes.  Treasuries can reasonably be held in taxable or tax deferred accounts.

About Treasury Inflation Protected Securities (TIPS)

The principal amount of a TIPS adjusts to increase with inflation or decrease with deflation, as measured by the CPI. However, the maturity value of a TIPS is the original principal amount (”par”) or the adjusted principal, whichever is greater.

TIPS pay interest twice a year, at a fixed rate (not a fixed amount). The fixed rate is applied to the inflation/deflation adjusted principal.  Therefore, the interest payments rise with inflation and fall with deflation.

If inflation occurs while you hold TIPS, each interest payment will be higher than the last. If deflation occurs, each interest payment will be lower than the last.  At maturity, the principal payment will not be less than par, but could be more than par if net inflation occurred during the life of the bond.

Both the interest earned as well as any increase in principal value on a TIPS are taxable at the Federal level for US-persons.  Since the increase in principal value is a non-cash income, TIPS are best held in tax deferred or tax-free accounts.

Inflation/Deflation After 1929 Crash:

There is a debate as to which past bear market is most like the current bear market.  In reality each bear and each bull is different — different economies, different regulations, different banking institutions, different political and geopolitical conditions, etc. — but comparisons are inescapable.

If we use the 1929 crash as a model, the post-crash inflation/deflation pattern may be helpful in thinking about TIPS.

The 5-year annualized deflation following the 1929 crash was 4.74%.  The 7-year annualized deflation was 2.76%.  For 10-years, the annualized deflation was 1.92%.  For 20-years to 1949, the annualized change in CPI was an inflation of 1.82%.

A longer-term CPI chart from 1900 to 2005 from a 2006 PIMCO article provides a comprehensive view of CPI changes:

Implied Inflation in Current TIPS Pricing:

By subtracting the yield of a TIPS of a particular maturity from the yield of an ordinary Treasury bond of the same maturity, you obtain the implied annualized inflation over the time to maturity.

The three tables below show the implied inflation for 5, 7, 10 and 20 years as of January 2, July 27, and December 24 of 2008.

You can see that the implied inflation at the beginning of 2008 was positive, and that it rose to a larger positive number by late July.  However, now it is implying deflation for 7 years, with a minor return to inflation after 10 years, and low inflation for 20 years.

Our Best Guess on Post-Bear Market CPI Changes:

Because of the massive global, multi-national reflationary government programs, we doubt that the 10 years following this bear market will be as deflationary as the 10 years following 1929.  In fact, we are concerned about too much being done too late with consequent post-bear market inflation.

While we may have, or may be about to have, current deflation, it does not seem reasonable to us to project near zero inflation for 7-10 years as seen in current pricing.  We also doubt that annualized inflation will less than 1% over the next 20 years.  If those assumptions are correct, then TIPS would seem a better value today than ordinary Treasury bonds.

Relative Pricing TIPS and Ordinary Treasuries:

The following charts plot the ratio of TIP to IEF. TIP is an ETF investing in TIPS, while IEF is an ETF investing in ordinary Treasury bonds.

They aren’t perfectly aligned in duration, as would be the case with individual TIPS and ordinary Treasuries of the same maturity, but the ETF comparison is a reasonable rough match for relative pricing in this discussion.

The average duration of TIP is 5.67 years, while the average duration of IEF is 6.99 years.

You can see by the sharply reduced ratio since mid-2008 that inflation expectations have dramatically reduced.

Plotting the performance of TIP and IEF separately, they look like this:

TIP versus IEF Weekly for 3 Years

TIP versus IEF Daily for 3 Months

Summary:

TIPS are anticipating no inflation for at least 7 years, minimal inflation for 10 years and low inflation for 20 years.

If inflation occurs, TIPS would appreciate in maturity value and increase in semi-annual interest payments.

If deflation occurs, they would have the same par value at maturity as ordinary Treasuries, but the semi-annual yield would decrease in line with the deflation.

Because we believe inflation is at least somewhat more likely than deflation over the next 5-10 years, and certainly over 20 years, we think TIPS are attractively priced now.

If interest rates rise due to a reduction in fear and a move out of Treasuries into riskier assets, but not due to a measured rise in Consumer Price Index, TIPS would decline in market value, as would ordinary Treasuries.  However, if interest rates rise due, at least in part, to a rise in CPI, TIPS would increase in interest and market value, while ordinary Treasuries would decline in market value with interest amounts remaining constant.

For these reasons, we think investors with a desire to hold Treasury debt, should hold some TIPS as well as ordinary Treasuries (with TIPS in a IRA or other tax deferred, or tax-free account).

That said, 2+% interest, whether real (TIPS) or nominal (ordinary Treasuries) is not attractive for a large portion of most portfolios.

Richard Shaw
QVM Group LLC

In a recent post about “bubbly” Treasuries, we got some comments that deserve attention.

First, this is briefly what we said;

“Treasuries have reached bubbly levels, both in terms of low yield and the rate of change of price.

Interest rates will rise when the economy recovers, or when bond buyers demand more long-term interest to absorb trillions of new issues to fund recovery programs. Rising interest rates mean Treasury prices will fall.

… For investors who invest only “long”, closing long positions in long-dated Treasuries, or being alert to a trend reversal necessitating the closing of those positions is recommended.

… For investors who also invest “short”, being alert to a trend reversal creating a shorting opportunity is recommended. The current trend is strongly upward, but could reverse dramatically …”

Some commenters agreed and some did not.

A supportive comment was;

“The safe haven play into Treasuries is demonstrating a true example of a parabolic move. Parabolic moves are unsustainable.”

This amalgam of questioning or counter arguments from commenters is worthy of discussion:

1. there is not yet technical confirmation of a trend reversal
2. shorting now could result in big losses
3. Treasuries are a safe haven play that may persist for a long time
4. the Fed may put a bid under the long bond to keep rates low
5. the Fed said we face “low interest rates for some time”

We have these thoughts about those concerns:

1) We agree there is no technical confirmation of a trend reversal, but sudden parabolic rises may be followed by sudden parabolic declines.  The risk of losses from here due to sudden drops in price (because of diminished fear), even with trailing stops, may be greater than the potential for gain from rates possibly falling further.  The easy money has been made in Treasuries.

2) We agree that shorting long Treasuries now is not justified on a technical basis at this time, although it may be justifiable from a fundamental basis before it is justifiable technically. Our recommendation was and is for short players to be on close alert to a shorting opportunity which may materialize soon — not to short yet — the technicals are still positive, but the fundamentals may be negative — we prefer to be in a position long or short when the technical and fundamental logic is in accord.

3) The safe haven aspect of Treasuries is becoming less certain in the credit default swap markets, which recently had increased the price of default protection for Treasuries by 100 fold.  At some point, questions about the ability of the US to shoulder its newly magnified financial burden, and the prospect of long-term inflation, may cause Treasury buyers to demand higher rates (prices to fall). If rates stay low and at about the same level for a long-time, the recent capital gain aspect of Treasuries will vanish, leaving only an unsatisfactory long-term interest yield.

4) Without completely debasing the currency (which would create high inflation) the Fed cannot buy the bonds needed to be issued by the Treasury.  To make economic sense, new Treasury issuance must be purchased with existing currency held by other countries and other investors, not with IOU’s from the Fed.  The Fed buying from the Treasury, if more than transitory, is an economic illusion.

5) The Fed only controls very short-term inter-bank lending rates.  The markets set all other rates (unless, of course, legislation sets rate limits — what a disaster that would be).

Asset Allocation Implications

For those who do tactical allocation with periodic rebalancing, this is probably a better time than later to lighten up on long-term Treasuries, moving either to shorter maturities to reduce sensitivity to long-term rate changes, or to lower credit quality for higher yield.

As general adherents to the reversion to the mean principle, and having mistakenly ridden bubbles to the top and then back down in prior experience, we are conservative enough to take some profit now and reallocate to other less bubbly opportunities.

Technical View

The long bond is still in an upward trend, but it is getting tired.  That is why we recommend closing positions for those who prefer to take the great middle out of trends without stretching to attempt to catch the very tops and bottoms; or being alert to a possible near-term reversal for those those who prefer to catch as much of a trend after a reversal as possible.  Different strokes for different folks.

30-Year T-Bond Daily for 6 Months with Some Indicators

TLT (ETF long 20+Year Treasuries)

TBT (ETF 2X short 20+ Year Treasuries)

A Look at the Pundits’ Views:

In an unusual market, economic and government intervention situation such as we have, opinions are quite diverse and clearly divided on many issues.

Dec. 25 (International Herald Tribune) –  The U.S. government bond market, which towers above other assets as the only bastion of strong returns this year, could crumble in 2009.

Bloomberg published a general “bubble” statement in a recent lead paragraph;

Dec. 22 (Bloomberg) — The world’s biggest bond investors can’t stop buying Treasuries even though they’re comparing government debt to Internet stocks just before the technology bubble burst.

Let’s look at what some (not all) institutional managers have to say about Treasuries:

Dec. 11 (Bloomberg) — “Treasuries have some bubble characteristics, certainly the Treasury bill does,” said Bill Gross, co-chief investment officer of [PIMCO], which oversees the world’s largest bond fund. “A Treasury bill at zero percent is overvalued. Who could argue with that in terms of the return relative to the risk?” …

David Rosenberg, the chief North American economist at New York-based Merrill Lynch, said last week that demand for Treasuries had reached the “bubble” phase like in technology stocks in 2000 and real estate six years later. …

Another article the same day said;

Dec. 11 (Bloomberg) — The rally in Treasuries that pushed yields on bills below zero percent this week is adding to concerns that the $5.3 trillion market for government debt is a bubble waiting to burst. …

“At some point we are going to get some signal, some indication that this massive policy response is getting some traction,” said Mitchell Stapley, who oversees $22 billion as chief fixed-income officer for Grand Rapids, Michigan-based Fifth Third Asset Management. “The flight out of Treasuries is something that will be breathtaking.”

How long can non-existent returns be acceptable to investors?  Not that long, we would think.

Last week, Jim Rogers said in a 2009 outlook video at Bloomberg;

“[the long bond] is the last bubble left .. it is clearly a bubble”.

Jim Grant was quoted on in Bloomberg for his December 17 statement:

“Government plans to sell $2 trillion of debt … are setting investors up for losses, said James Grant, editor and founder of … Grant’s Interest Rate Observer. … ‘What it speaks to is the illusion that some securities are inherently safe or inherently valuable. … People are piling into Treasuries now … I don’t know what they’re priced for, but they’re not priced for life as I know it in this economy.’ ”

Others, however, see Treasuries differently and more favorably:

Dec. 25 (International Herald Tribune) –  “Either we get deflation or not,” said Jay Mueller, a senior portfolio manager with Wells Capital Management in Milwaukee. “If we get meaningful deflation, Treasuries will still be the place to be. [but] …  if we don’t get the deflation, that will make current Treasury yields look unrealistic and you will do a lot better” in corporate bonds. Mueller put the odds of the U.S. economy skirting sustained deflation at about 60 percent.

Dec. 22 (Bloomberg) –  “There’s probably a little more room for the Treasury market to run,” said Thomas Girard, a money manager who helps oversee $110 billion in fixed-income assets at New York Life Investment Management in New York. “We’ve been very, very gently trying to add some non-Treasury-related holdings into the portfolio, but that’s been a very slow process simply because of the powerful rally in Treasuries.”

… Van Hoisington, president of Hoisington Management, which oversees $4.5 billion, said there is no bubble and that long-term Treasury yields have room to fall. … At a yield of 2.56 percent, a rally to 2 percent in the next 12 months would produce a 13 percent return. …“If you accept the fact the economy’s going to be slow-growing for the next three or four years and inflation in fact is going to zero then it would be a bargain,” Hoisington said.

Long-Bond Prices and Rates As of December 24th:

The bond price plotted in black is shown on the right scale.  The bond yield plotted in red is shown on the left scale.

30-Year T-Bond, Monthly for 19 Years from 1990

30-Year T-Bond, Weekly for 1 Year

30-Year T-Bond, Daily for 3 Months

Most relevant ETFs are TLT (long 20+ year Treasuries) and TBT (2X short 20+ year Treasuries).  Futures can be used to directly target the 30-year bond.

Richard Shaw
QVM Group LLC

Treasuries have reached bubbly levels, both in terms of low yield and the rate of change of price.

Interest rates will rise when the economy recovers, or when bond buyers demand more long-term interest to absorb trillions of new issues to fund recovery programs. Rising interest rates mean Treasury prices will fall.

Consider these charts plotting the interest rate on 10-year  and 30-year Treasuries versus the price of 10-year and 30-year Treasuries. Price and yield are near perfect mirror images.

The 19-year history of the monthly yields shows a steady decline, followed by a precipitous drop in Q4 2008. There is little room for further decline, and reasons to believe that rates must rise. Long-term investors, for example, cannot be expected to be content to earn 2+% forever.

Long-term history of rates shows there is much more room for rates to rise than to fall. We don’t know when rates will rise or by how much.

The Ten-Year T-Bond

The 10-year average interest rate for the 10-year bond is 4.68%, while the current rate is 2.18%.

click images to enlarge

10-Yr T-Bond Yield versus 10-Yr T-Bond Price

Yields are shown as a solid black line. Prices are shown as a dashed red line. The 10-year simple moving average yield is shown as a dashed blue line. The current 10-year average yield is indicated as a green horizontal line. The price range for Treasuries when yields were in the vicinity of the 10-year average yield is bounded by a green oval.

The Thirty-Year T-Bond

The 10-year average rate for the 30-year bond is 5.27%, while the current rate is 2.55%.

30-Yr T-Bond Yield versus 30-Yr T-Bond Price

The charts visually suggest a coming significant fall in the prices of 10-year and of 30-year Treasuries in a mean reversion as general business conditions improve.

Treasury Futures

Futures charts for the 10-year and 30-year bonds tell the same story. The relative strength index (RSI) shows an overbought condition for the 30-year bond and a recently overbought condition for the 10-year bond.

10-Yr T-Bond March ‘09 Futures (with RSI study)

30-Yr T-Bond March ‘09 Futures (with RSI study)

Recommendation:

For investors who invest only “long”, closing long positions in long-dated Treasuries, or being alert to a trend reversal necessitating the closing of those positions is recommended.

For investors who also invest “short”, being alert to a trend reversal creating shorting opportunity is recommended. The current trend is strongly upward, but could reverse dramatically if a Treasury auction brings higher rates. The decline in prices could be as sudden and precipitous as the rise, as the recent gap down in the 10-year futures contract hints.

In either case, whether holding long or short positions, we recommend using persistent trailing stops to minimize the loss potential, while letting profits run.

Investment or Trading Vehicles:

Stock investors can use exchange traded funds.  Futures contracts are available to those with accounts at futures dealers.  There are also Put and Call options traded on some of the Treasury ETFs through stock brokers.  On the long side only, there are low cost mutual funds available.

• Treasuries from 7-10 years are held by the ETF symbol IEF
• Treasuries of 20+ years maturity are held by the ETF symbol TLT
• Treasuries from 5-10 years are held by the MF symbol VFITX
• Treasuries from 15-30 years are held by the MF symbol VUSTX.

IEF has a 3-month average daily volume of 525,000 shares, and TLT has a 3-month average daily volume 2,924,000 shares.

Both may be shorted, but the inventory for shorting TLT is limited, making that impractical to impossible, depending on the broker used.

There are two double-short Treasury ETFs that can be held long to create the economic opportunity of shorting while limiting maximum risk to no more than the invested amount (compared to direct shorting, which in theory could put more than the invested amount at risk).

• PST for Treasuries with maturities of 7-10 years
• TBT for Treasuries with maturities of 20+ years.

PST has a 3-month average daily volume of 133,000 shares, and TBT has a 3-month average daily volume 3,258,000 shares.

Puts and Calls also have the advantage of limiting loss potential to the amount invested, but they are more volatile than the underlying security, and have an expiring time value, as do futures contracts.

* * * * *

INVEST WITH CARE. Seek to reach your return objectives while managing your risk.

Richard Shaw
QVM Group LLC

There is nothing left in the charts to suggest support for the S&P 500 index if it pierces the approximate 800 level (roughly 80 for its proxy SPY).

The index has been volatile within a range between generally 850 and 1,000 over the past few weeks.

Only fundamentals remain to gauge opportunity. The fundamentals of “E” stink. The fundamentals of P/E are not supportive, because the ratio is above the long-term average.

If the index pierces 800 (SPY goes below 80), it will resemble the Road Runner cartoon character Wiley Coyote when he would race off the edge of a cliff to find himself suspended in mid-air over a deep canyon.

Wiley’s attempts to run on air back to the solid cliff never worked. We hope if that happens to the S&P index, it can catch a branch as sometimes happens in the movies to break its fall.

See our prior study of charts suggesting a possible 400 to 800 range for the S&P index, and our prior study comparing the long-term index “as reported” trailing P/E ratio to the current ratio.

click image to enlarge

We hope for the best, but have prepared for the worst. Admittedly, our mentality for some months now resembles the 1950’s bomb shelter mentality.  Not to worry though, we have plenty of canned food and water stored in our financial hideaway built of cash and bonds.

Accounts we manage are 80% to 90% cash, with most of the invested portion in corporate, Treasury and municipal bonds.  We have made minor, but punishing test investments in equities since late summer, without success.  We use trailing stops on all of our positions.

We have decided to be late to the party on the way back up to avoid destroying capital on the way down.  In such an historic period of negative economic and stock market records, we think the math favors letting braver souls create the eventual reversal.  We will invest later, unfortunately having to climb over the bleached bones of those who courageously went before us only to fall to the canyon bottom.

We will go back in, but not yet.  Minimizing risk is more important than maximizing return for most of our clients whose portfolios are mature, and who cannot replace the assets within them.  Better to avoid loss now and then do OK after a confirmed trend reversal, than to risk massive loss in the current market in an attempt to predict the trend reversal to capture all the potential on the way up.

Lottery operaters say to gamblers, “you can’t win if you don’t play”.  We say to investors, “you can’t play tomorrow, if you don’t survive today.”

We hope our re-entry comes soon, but we have no way to predict when the time will be right.  However, it should be possible to recognize when time is right when it arrives by focusing on fundamental measures of value, by waiting for mean reversion to be on our side, and for apparent levels of risk to be much smaller.

Richard Shaw
QVM Group LLC

Financial Week, November 2, 2008

Jeremy Grantham, chairman of Boston-based GMO LLC and a renowned wet blanket in the face of irrational exuberance, sounds uncharacteristically giddy these days.

… equity markets are “below trend lines” for the first time since 1994.

… CFOs should phase back into equities “with all deliberate slowness, as opposed to all deliberate speed,” Mr. Grantham warned, noting that markets typically overshoot on the downside by 20% or more.

… He predicted that the scars from the current downturn will be long lasting, and the effect on the money management industry profound. “A very substantial fraction of a generation of investors” is likely to be leery of stocks, just as they were in the 1930s, “40s and “50s, and again for most of the “70s, he said.

This is “truly the end of an era, and almost everything will be re-evaluated,” from interest in leverage-dependent hedge fund and private equity strategies, to asset allocation, to how institutional investors handle their liquidity needs, Mr. Grantham said.

At the end of the day, he said, people will have a different view of risk—”a much more realistic view of how hard it is to generate alpha.”

Barron’s Monday November 3, 2008:

(by Alan Abelson)

All told by one rough reckoning, global equities in October shed a tidy $9.5 trillion.

…We seemingly don’t have to worry about inflation … because … we have to start worrying about deflation … guaranteed by the government’s unbridled resort to its magical money machine.

(by Michael Santoli)

… the most out-of-consensus trade might be the one that bets on a return to normalcy. …

It’s almost certainly too early to declare we’ve arrived here, when the Federal Reserve is the main buyer of commercial paper on a daily basis, and just after the best week for the Dow in 34 years completed the worst month since 1987, and when the final 15 minutes of the trading day is a pull of the slot-machine arm.

… The worst of the economic data is well ahead of us, as is what’s likely to be a grinding and radical cycle of cutting corporate profit expectations. The crucial question: How much of this is priced in? The forward price/earnings multiple of the median stock in the broad Value Line stock universe last week was 12.1. It hasn’t been that low since 1991, when 10-year government paper yielded 7%.

… The market hasn’t proven much in this bounce — yet — aside from what we all knew a week ago: Stocks had fallen a ton in a very short time, and were badly overdue for a rally.

(by Jacqueline Doherty)

Are stocks fairly valued or headed for a big fall? That’s a difficult question to answer right now …

Analysts currently estimate that earnings for the companies in the S&P 500 will rise … to a record $91.41 a share, according to Thomson Reuters.

… Five prominent strategists we polled last week expect earnings for the S&P 500 to fall 15% this year and 3% next year, to roughly $70 a share.

If the strategists are right, stocks are pretty fairly valued right now. The S&P 500 was trading Friday at 960, or 13.7 times the strategists’ $70 earnings estimate for 2009. For the past 30 years, stocks have traded at an average of 13.7 times expected earnings. So 13.7 times depressed earnings seems pretty reasonable. …

… In past recessions, earnings multiples have fallen well below the average. In the 1975 recession, the market’s trailing P/E sank to 7.28, and in the 1980 downturn it shrank to 6.84.

(by Deutsche Bank Private Wealth Management, NY, NY)

Investors who have cash to put to work [would] be prudent to resist the temptation to dramatically increase equity exposure until there’s greater clarity…rebounds [like those seen last week] can be followed by sharp pullbacks that retest the market bottom.

(by Portfolio Management Consultants/Envestne, NY, NY)

No empirical data suggest we have bottomed or are about to. It’s more rational to suggest we’re closer to fair-market value. Corporate earnings and profit margins are about to run into a declining global economy and a domestic consumer segment that’s seriously deleveraging…we don’t expect a sustained V- shaped recovery in equity valuations.

(by MKM Partners, Greenwich, CT)

The Case-Shiller Home Price indexes dropped sharply in September… consumer confidence collapsed in October to the lowest level since records began in 1967. The fraction of respondents who said jobs were harder to get in October jumped by the largest margin since May 1980.

(by Harloff Investment Advisors, Olmstead, OH)

Because of the significant worldwide bank cooperation and money infusion we feel this liquidity crisis will soon be under control and will stop the bear markets. Value investors are buying cheap equity assets. We believe current buying opportunities outweigh future stock-market losses. It is time to think of the next bull market.

Short-Term Returns for Key Assets:

Weekly updated return charts for these and many other assets are available on our site:

click image to enlarge

Richard Shaw
QVM Group LLC