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I don't understand the wild swings in TIPS funds (especially in PRIIX which seems to hold high percentage, but also HARRX which seems less volatile). If investors become more worried about inflation and pile a lot into TIPS, does that mean the price/value will drop? Or maybe I'm not even asking the right question. What is your opinion of having a max combined 7% in these two funds given the economic outlook?
Tips are more sensitive to changes in real yield than treasury, which is to say that if inflation expectation remains constant but the yield rate changes, TIPs will fluctuate more in price than vanilla treasuries.
If investor become more worried about inflation, the price of TIPS will rise and yields will drop. The appropriateness of TIPS has to do with inflation expectations and should help to hedge inflation risk. Currently, the 10-year treasure is yielding 2.56% and the 10-TIPS is yielding 0.31 for a breakeven of 2.25. This is (roughly) what the market expects inflation to be over the next ten years. If its more than this TIPS will out perform and if less than this Treasuries will out perform.
It would be difficult to gauge the appropriateness of holding a certain level of TIPS without looking at how it fit into the larger bond portfolio.
Thanks so much, Nick, for your very clear explanation - helped me a lot! Only part I don't understand is where you got the breakeven of 2.25 on TIPS if current yield is 0.31 (or even what "breakeven" means. Clearly a lot more I need to learn.
TIPS pay a lower yield than Treasuries but have the principle adjusted to reflect inflation. Their "real" yield is the yield the TIPS pay over and above the inflation adjustment. Because Treasuries do not pay an inflation adjustment and because TIPS and treasuries of the same maturity have the same credit and duration risk, the difference in yield between the two is Inflation expected by the market. This is called the breakeven rate and it is roughly the difference between a Treasury Bond and a TIPS of the same length.
Another way of thinking of the breakeven rate is the amount of inflation you have to get over the life of the TIPS to get an equal return as a Treasury bond. If inflation is greater, the TIPS earns more, if the inflation is less the Treasury earns more but if inflation is at that rate, the two break even.
EXCELLENT CLARIFICATION, Nick, thank you! It sounds like you understand these really well to be able to give such a concise clarification. Would you mind telling me if you think that current TIPS pricing/expectations are below or above what you think the reality will be in the next couple of years.
I don't really have an informed opinion; generally I would expect low inflation (less than 2%) the next 5-years or so but that is roughly inline with what the market expects and I don't really know which is more attractive. I'm not really much of a speculator and have the bond portion of my portfolio invested with managers with a flexible charter and willing to take on more credit risk.
Morn'in Cathy, NickF presented a nice write regarding TIPS functions. I still do contend that the upward gains in TIPS this year comes more from the relationship to safety of Treasury issues. One must know and consider that many bond funds and soverign wealth funds (China and others) do not only buy the more obvious Treasury issues, but also U.S. TIPS. As I have noted in the past at FA, our portfolio is not so much or only a function of a given yield, but a consideration as to the monies flowing into a bond sector and causing a price appreciation. Yes, we are chasing performance (price appreciation); although some bond funds move in slow motion when compared to equity funds....nickel, dime; nickel dime. And yes, we here are performance chasers to one degree or another, eh? Otherwise, MFO would CDO (Cert. of Deposit Observer) and all of us would be discussing who or what is offering the best CD rate of the day. One may expect another decent performance in TIPS funds today; perhaps thru the week, and until the current equity unwind finds the money flows into a "bottom feeding" mode and buying low. Regards, Catch
Reply to @NickF: Thanks for your follow-up, Nick. I was surprised that you have investment managers managing your bond investments as you seem extremely knowledgeable about these... more than enough to manage them yourself without paying a fee. On the other hand, if you have good managers who have done well for you, then it is great for you not to have the endure the headaches of times like these and let them worry about it.
Reply to @catch22: Hi Catch. You are definitely one of the main members here who have extensive knowledge of bond funds so I always appreciate your input. I think my main hurdle to get over has been to think in terms of investor "expectations" rather than what I perceive is the reality of the outlook ahead. My fairly minor investments a few months ago in Gold (IAU) and Swiss Francs (FXF) went against my logical presumption that both were way overpriced then. But those two investments have done amazingly well since then (Rono must be ecstatic with his large gold investments - and your primarily bond funds certainly ended up ahead of the game).
Comments
If investor become more worried about inflation, the price of TIPS will rise and yields will drop. The appropriateness of TIPS has to do with inflation expectations and should help to hedge inflation risk. Currently, the 10-year treasure is yielding 2.56% and the 10-TIPS is yielding 0.31 for a breakeven of 2.25. This is (roughly) what the market expects inflation to be over the next ten years. If its more than this TIPS will out perform and if less than this Treasuries will out perform.
It would be difficult to gauge the appropriateness of holding a certain level of TIPS without looking at how it fit into the larger bond portfolio.
Another way of thinking of the breakeven rate is the amount of inflation you have to get over the life of the TIPS to get an equal return as a Treasury bond. If inflation is greater, the TIPS earns more, if the inflation is less the Treasury earns more but if inflation is at that rate, the two break even.
Hope this helps.
And yes, we here are performance chasers to one degree or another, eh? Otherwise, MFO would CDO (Cert. of Deposit Observer) and all of us would be discussing who or what is offering the best CD rate of the day.
One may expect another decent performance in TIPS funds today; perhaps thru the week, and until the current equity unwind finds the money flows into a "bottom feeding" mode and buying low.
Regards,
Catch