TAG | Interest rate
28
Here's a Hot "TIP" You Shouldn't Buy
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Here’s a Hot “TIP” You Shouldn’t Buy
by Alexander Green, Investment U’s Chief Investment Strategist
Thursday, October 28, 2010: Issue #1376
Six months ago, I made a strong case for buying inflation-adjusted Treasuries, better known as TIPS.
I suggested that Washington’s massive fiscal stimulus, plus record-low interest rates, might ultimately prove inflationary.
So far, they haven’t. But investors clearly feel that inflation – the thief that robs us all – is just around the corner.
Look at the traditional inflation harbinger – gold. The metal has hit one new high after another this year.
TIPS (Treasury Inflation-Protected Securities) have soared, too. In fact, they’ve rallied so far that for the first time ever, five-year TIPS were sold at auction earlier this week with a yield of minus 0.5%.
That’s right… they guarantee a negative yield. Yet investors are gobbling them up anyway.
What’s going on here? Let’s start at the beginning…
The Inside Track on TIPS
Here are some Treasury Inflation-Protected Securities (TIPS) characteristics…
- They pay interest every six months, just like a regular Treasury bond.
- Unlike traditional bonds, your principal increases each year by the amount of inflation, as measured by the consumer price index (CPI). The semi-annual interest payments also increase by the amount of inflation.
- The interest you receive is exempt from state and local income taxes (but not federal).
- TIPS are less volatile than traditional bonds.
- TIPS are excellent diversifiers.
But can TIPS possibly be worth holding, even when they sport a negative yield?
Perhaps for long-term investors (as I’ll explain in a moment). But not for short-term traders. Here’s why…
Think Twice Before Buying TIPS for the Short-Term
Current yields of less than zero on TIPS are due to rock-bottom Treasury rates and fears of higher inflation just over the horizon.
It’s simple math. Five-year Treasuries are yielding a paltry 1.2%. Given the weak dollar and Washington’s addiction to spending, traders and investors are betting that inflation will run at 1.7% or more.
That makes five-year TIPS just as attractive as five-year bonds, since 1.7% minus the 0.5% negative yield equals 1.2%.
Inflation or Disinflation?
Of course, the financial markets are a bit schizophrenic right now. Inflation protectors like gold and TIPS have rallied. But so have inflation-sensitive investments like investment grade bonds. Investors can’t seem to decide whether we’re in for inflation or disinflation.
And of course, nobody knows for sure. But TIPS have rallied by 10% over the last year, with no uptick in inflation. If the folks betting on disinflation – or its more severe cousin, outright deflation – are right, these bonds could undergo a serious price adjustment, giving investors a haircut in the process.
TIPS investors aren’t just guaranteed negative yields right now. They may also experience a negative total return for several years in a row.
So why shouldn’t long-term investors sell them outright?
How to Tackle TIPS if You’re a Long-Term or Short-Term Investor
Some would be prudent to do just that. The only catch is this: What if the inflation hawks are right?
If they are, TIPS will give a higher future return than traditional fixed-income investments – and with the highest degree of safety. (They are, after all, obligations of the U.S. government.)
True, there are other inflation alternatives. But gold has already quintupled over the last decade. And that other famous inflation hedge – your home – is likely to remain mired in quicksand for years to come, thanks to the overhang of foreclosures and other unsold properties.
The bottom line is this:
- Long-term investors – those with a time horizon of five years or more – should hold onto their TIPS.
- But traders and other investors with a shorter time horizon should probably give them a miss.
History shows that once an asset class turns hot – whether it’s stocks, bonds, gold, real estate or TIPS – it rarely delivers the kind of returns it did when it was heating up.
This time could be different, of course. But that’s how investors always rationalize their investments at the top.
The oldest advice is still the best: Caveat emptor.
Alexander Green
21
Treasury Funds: Get These Time Bombs Out of Your Portfolio
0 Comments | Posted by Alexander Green in Alexander Green
Treasury Funds: Get These Time Bombs Out of Your Portfolio
by Alexander Green, Chief Investment Strategist
Monday, June 21, 2010: Issue #1285
Tens of millions of investors have a ticking time bomb in their fixed-income portfolios.
Are you one of them? If so, there’s still time to defuse it.
A few weeks ago, I wrote an Investment U column entitled, “Why the Safest Investment is Now One of the Riskiest.”
I noted that investors – frustrated by the microscopic yields on money market funds and certificates of deposit (CDs) – have poured money into longer-term Treasury funds.
Their thinking is simple. Too simple: “These funds yield over 5%, not bad in this environment, and the bonds they hold are guaranteed by the full faith and credit of Uncle Sam. What’s to worry about?”
Plenty…
Aren’t Treasury Funds Free of Risk?
Unlike individuals, corporations, and municipalities, the federal government can simply create money to meet any obligations. U.S. Treasuries are thus free of credit risk. But they aren’t free of interest-rate risk.
When interest rates go up, Treasury bond prices go down. Yet investors are comforting themselves that inflation isn’t currently a problem and that long-term rates remain near historic lows.
Don’t be fooled. There is a monster on the horizon – and he makes Beowulf’s Grindel look like Barney.
- Over the past 18 months, the federal debt has surged from $5.5 trillion to more than $8.6 trillion.
- Two years ago, it was 38% of GDP. Today, it’s 59% of GDP. And by the Congressional Budget Office’s own estimates, it’s going much higher still.
This is dangerous. Yet inflation has remained remarkably subdued so far. But understand that if the government opts to stimulate the economy further – especially if some emergency action is needed – short-term rates are already at zero.
Having already thrown the kitchen sink at the slowdown from a monetary standpoint, the federal government will almost certainly opt to spend even more dramatically.
The bond markets will not take this news well. Long-term rates are likely to spike. And when they do, it will get real ugly, real quick.
Investors always think they have time to move out of longer obligations before that happens. But that is not likely to be true…
The Triple Threat to Treasury Funds
Between early October 1979 and late February 1980, for example, the yield on the 10-year note rose almost four percentage points, driving a stake through most people’s bond portfolios.
Making matters worse, millions of Mom-and-Pop investors have unwittingly plunged into leveraged bond funds in recent years, often on their brokers’ recommendation.
Leveraged bond funds borrow money in the short-term to buy more longer-dated issues and enhance the funds’ yields. This is all well and good when rates are flat to lower. But when rates spike higher, look out below. The same thing will happen to these funds as to a margined stock portfolio in a correction. |
In fact, leveraged closed-end bond fund investors could get hit with a triple-whammy…
- The bonds in the fund will drop when interest rates rise.
- The drop will be compounded by the fact that the portfolio is leveraged.
- The fund could plunge to a deep discount to its net asset value, too.
Become a Bomb Disposal Expert… On Your Portfolio
Not pretty. So what to do?
- First, check to see what percentage of your portfolio is in long-term bonds. It shouldn’t be more than 10% as a maximum (as protection against a deflationary scenario).
- Second, visit www.etfconnect.com and type in the symbols for your fixed-income ETFs or closed-end funds.
Then look at the number beside the fund’s “effective leverage.” Zero means the fund is unleveraged. But some may be leveraged up to 40% or more. (That’s how these funds are able to yield more than the bonds they invest in, even after expenses.)
In sum, this is a time to pare back your long-term bond holdings and eliminate most of your leveraged holdings.
Don’t take these words lightly. There is danger on the horizon. But if you act now, there’s still time to get that ticking time bomb out of your portfolio.
Good investing,
Alexander Green
