Download TIPS: Opportunities for Active Management

STRATEGY
INSIGHTS
JULY 2014
TIPS: Opportunities for Active Management
by John Hendricks, Executive Vice President and Senior Portfolio Manager
When seeking to hedge against rising inflation, there are a number of investment options in the marketplace.
Treasury Inflation-Protected Securities (TIPS) are the most direct inflation hedge, as TIPS’ principal is linked to the
CPI-U (Consumer Price Index for All Urban Consumers). Other traditional inflation hedges typically display varying
degrees of sensitivity to inflation depending on the time horizon.
Once a decision is made to allocate to the TIPS asset class, the next question for investors is whether to adopt a
passive or an active strategy. TIPS, after all, are essentially a U.S. Treasury security (i.e. an efficient asset class)
and there are only 35 securities in the Barclays U.S. TIPS Index. The tendency is to conclude that there is limited
opportunity for an asset manager to outperform the benchmark. We would not agree with that conclusion.
Figure 1. Excess Return of TIPS over Nominal U.S. Treasures in Various Real Rate Environments
TIPS
Outperformed
10%
0%
0%
10-Year Real Rates
Jun-14
Jun-13
Jun-12
Jun-11
Jun-10
Jun-09
-10%
Jun-08
Jun-07
-4%
Jun-05
-2%
Jun-06
U.S. Treasuries
Outperformed
1-Year Rolling Excess Return
20%
2%
Jun-04
Real Rates
4%
-20%
1-Year Rolling Excess Return
Excess Return = Barclays U.S. TIPS Index 1-Year Rolling Return minus Barclays U.S. Treasury Index 1-Year Rolling Return. 10-Year Real Rates is represented by
10-Year Generic Inflation Indexed U.S. Treasury bonds.
Source: Bloomberg, Barclays Live as of 6/30/2014. Past performance is no guarantee of future results.
In our opinion, an active management style may lead to long-term outperformance versus a passive approach.
We would go even further and assert that an active manager may outperform while pursuing a “pure” style,
which we equate to maintaining on average a high allocation (≥90%) to inflation-linked bonds over time.
Some inflation hedging strategies incorporate other asset classes to attempt to enhance portfolio yield and
return. Our approach has been to preserve the potential diversification benefits of the asset class while at the
same time capitalizing on the unique characteristics of TIPS. The TIPS asset class is not so efficient that a
manager can’t outperform versus the benchmark or remain competitive versus a varied peer group.
Active managers, of course, have the ability to incorporate macro views and relative value strategies into their
investment process. The following highlights a number of approaches that may allow active mangers to outperform
versus the benchmark and seek to protect clients when market conditions turn unfavorable for the TIPS asset class.
FOR INSTITUTIONAL INVESTOR AND CONSULTANT USE ONLY. NOT FOR USE WITH THE GENERAL PUBLIC.
JULY 2014
TIPS: OPPORTUNITIES FOR ACTIVE MANAGEMENT
Figure 2. U.S. TIPS 10-yr Breakeven Rates, 2009-2014
Rotation Between TIPS and Nominal
Treasuries May Enhance Return
2.8
Active managers can potentially capalitize on the
fluctuation in TIPS breakevens.
»» TIPS fall in and out of favor in the marketplace and this is
most readily apparent in breakevens. Tactically allocating
away from TIPS when inflation expectations are falling
(or likely to fall) may enhance performance (see Figure 2).
2.6
2.4
Percentage
2.2
2.0
1.8
06/14
03/14
12/13
09/13
06/13
03/13
12/12
09/12
06/12
03/12
12/11
09/11
06/11
03/11
12/10
09/10
06/10
03/10
12/09
09/09
1.4
06/09
1.6
Source: Bloomberg, as of June 30, 2014
Figure 3. U.S. TIPS 10-yr Breakeven Rates, 2013-2014
2.6
2.4
Percentage
»» The most striking example of TIPS underperformance
was during the financial crisis, when the economy
experienced negative growth and deflation (see Figure 1).
Bernanke testimony on 5/22/2013:
“In the next few meetings, we could take
a step down in our pace of purchase.”
2.5
»» As a rule, TIPS have performed best in a stagflationary
environment (i.e. low to declining growth and rising
inflation).
2.3
2.2
2.1
06/14
05/14
04/14
03/14
02/14
01/14
12/13
11/13
10/13
09/13
08/13
07/13
06/13
05/13
04/13
03/13
02/13
01/13
2.0
1.9
»» The volatility of returns in various maturity buckets may
present active managers with opportunities to outperform
(see Figure 4).
Jun-14
Dec-13
Jun-13
Dec-12
Jun-12
Dec-11
»» Once again, the 2008 financial crisis provides a dramatic
example of curve opportunities. In 2008, the real yield
curve inverted and then normalized the following year
(see Figure 5).
Jun-11
Percentage
Figure 4. TIPS Excess Return Vs Index by Maturity
— Barclays U.S. TIPS 0-5 Year Index — Barclays U.S. TIPS 5-10 Year Index
— Barclays U.S. TIPS 10+ Year Index
U.S.
TIPS 0-5
Excess is comparison
to Barclays
U.S.Years
TIPS Index.
U.S. TIPS 5-10 Years
U.S.
TIPS
10+
Years
Source: Barclays Live, as of June 30, 2014. Past performance is no guarantee of future results.
Figure 5. Real Yield Curves 2007-2009
6
12/31/2007
12/31/2008
12/31/2009
5
Percentage
4
3
»» Since the inception of the TIPS asset class in 1997, the
Barclays U.S. TIPS Index has had only two negative
return years (2008 & 2013). In 2008, the TIPS curve
inverted and the Barclays U.S. 1-5 Year TIPS Index
suffered a negative total return of -5.71% while the
Barclays U.S. 10+ Year TIPS Index had a positive
return of 1.12%. The full index had a negative annual
return of -2.35%.
Inflation Compensation is Important
– but Don’t Overlook Price Return
»» TIPS expose investors to interest rate risk and investors
will likely suffer lower returns if rates rise with inflation.
»» Active managers can manage interest rate risk by
astutely positioning along the real yield curve or by simply
underweighting duration risk versus the benchmark.
2
1
30Y
20Y
10Y
5Y
2Y
0
-1
Positioning On the Real Yield Curve
May Have a Dramatic Impact
»» Near-term realized inflation and inflation expectations
heavily influence shorter-maturity TIPS. Longer-maturity
TIPS are influenced more by nominal yields.
Source: Bloomberg, as of June 30, 2014
5
4
3
2
1
0
-1
-2
-3
-4
-5
»» A recent example of this would be when Federal Reserve
(Fed) policymakers started in May 2013 to communicate
their intent to exit Quantitative Easing (QE). The more
hawkish Fed communication and a benign inflation
backdrop caused breakevens to trend lower (see Figure 3).
»» Overlaying derivative strategies may also help insulate
a TIPS portfolio in adverse environments.
Source: www.treasurydirect.gov
FOR INSTITUTIONAL INVESTOR AND CONSULTANT USE ONLY. NOT FOR USE WITH THE GENERAL PUBLIC.
2
JULY 2014
TIPS: OPPORTUNITIES FOR ACTIVE MANAGEMENT
TIPS Valuations Periodically Diverge
from the Fundamentals
Figure 6. Difference in Inflation Indicators
Monthly % difference between non-seasonally adjusted (NSA) and
seasonally adjusted CPI.
0.60%
»» As an example, during “flight–to-quality” episodes
TIPS have typically lagged the broader nominal market.
180M Avg
2013
2014
0.50%
0.40%
Percentage
»» TIPS liquidity is not comparable to liquidity in the nominal
market, and this difference may create opportunity.
0.30%
»» Auction dynamics tend to be more pronounced with
TIPS. New issuance may distort pricing along the curve
and in so doing create opportunity.
0.20%
0.10%
0.00%
-0.10%
-0.20%
-0.30%
-0.40%
1
2
3
4
5
6
7
8
9
10
11
12
Months
Source: Bloomberg, as of May 31, 2014
»» TIPS flows may be strong around the seasonal inflation
pattern as investors seek to capture the high inflation
accrual or “positive carry.”
Figure 7. Differences in U.S./German 5-Yr ,
10-Yr Breakevens
5-Yr Breakevens
3.00
U.S. 5-Yr
Breakeven
2.50
Percentage
1.50
1.00
German 5-Yr
Breakeven
0.50
0.00
-1.00
07
08
09
10
11
12
13
14
10-Yr Breakevens
3.00
U.S. 10-Yr
Breakeven
2.50
2.00
Percentage
»» This may create significant cross market opportunity
for managers that can allocate to non-dollar linkers (see
Figure 7).
»» We appear to be entering one of those periods of
divergence with U.S. and U.K. monetary policy about
to tighten and euro area policy easing.
-0.50
1.50
1.00
German 10-Yr
Breakeven
0.50
0.00
-0.50
Opportunity Resides in Global Inflationlinked Bonds
»» Periodically macro divergences between developed
economies steps up.
2.00
-1.50
»» Seasonal inflation accrual impacts TIPS demand and
issue-specific pricing. TIPS of varying maturity months
exhibit seasonal patterns due to the fact that TIPS
are tied to the non-seasonally-adjusted (NSA) inflation
index rather than the seasonally-adjusted version.
NSA monthly inflation, in turn, has exhibited a fairly
predictable pattern, whereby inflation typically has
been highest in the first half of the year and lowest in
the latter half (see Figure 6).
07
08
09
10
11
12
13
14
Conclusion
The above market data demonstrates that there may be
sufficient opportunity in the TIPS market for active managers
to outperform. Given past market behavior and the trading
dynamics we highlighted, an active TIPS strategy may benefit
the performance of a portfolio versus a TIPS index and a
passively managed approach.
Going forward, fixed-income investors will likely face greater
uncertainty around inflation and interest rates. As the U.S.
Federal Reserve seeks to normalize policy after years of
unconventional measures, U.S. interest rate volatility will
likely pick up. Active management during this transition
period could mitigate a number of portfolio risks.
Source: Bloomberg, as of June 30, 2014
FOR INSTITUTIONAL INVESTOR AND CONSULTANT USE ONLY. NOT FOR USE WITH THE GENERAL PUBLIC.
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TIPS: OPPORTUNITIES FOR ACTIVE MANAGEMENT
JULY 2014
About the Author
John Hendricks
Head of Global Rates/FX
Executive Vice President
Senior Portfolio Manager
Hartford Investment Management has $1.5 billion in TIPS assets under management as of March 31, 2014, and
uses an active management style in an effort to outperform the Barclays U.S. TIPS Index over a market cycle.
Disclosure
The forecasts, opinions and estimates expressed in this report constitute the Firm’s judgment as of June 30, 2014 and are subject to change without
notice based on market, economic and other conditions. All investments are subject to risk, including possible loss of principal. TIPS are subject to the
risks associated with inflation-protected securities (“IPS”). Risks associated with IPS investments include liquidity risk, interest rate risk, prepayment
risk, extension risk and deflation risk (with deflation, the principal value of IPS holdings would be adjusted downward). Diversification cannot assure
against market loss.
These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice. All data contained in this is
from sources deemed to be reliable, but cannot be guaranteed as to accuracy or completeness.
Hartford Investment Management Company is a registered investment adviser subsidiary of The Hartford Financial Services Group, Inc.
(SEC registration does not imply a certain level of skill or training).
© 2014 Hartford Investment Management Company. All rights reserved.
One Hartford Plaza | Hartford, CT 06155 | 866.403.4733 | www.himco.com
At HIMCO our sole business is asset management. We are focused on a clearly defined mission — understanding
our clients’ needs and providing long-term investment strategies. We are value-oriented investors, and we believe the
best way to capture opportunities for our clients is a balanced top-down, bottom-up approach, supported by strong
fundamental and quantitative research with an emphasis on risk management at every step of the process. Entrusted
with $114.3 billion in assets under management as of March 31, 2014, we execute this approach on behalf of a wide
range of clients.
14-0267/14H147
FOR INSTITUTIONAL INVESTOR AND CONSULTANT USE ONLY. NOT FOR USE WITH THE GENERAL PUBLIC.
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