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Leveraging Our Play on TIPS

Here's why we believe TIPS will make a strong move in the long run

By Michael Fabian, FMD Capital Management

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For those that follow Treasury bond fluctuations closely, it’s been hard not to notice the persistent under performance in Treasury Inflation Protected Securities (TIPS) versus nominal coupon bonds over the last several years.  It’s no surprise that inflation has been running below expectations for a long time, despite a steadily falling unemployment rate and a generally improving economy.   Nevertheless, from a technical and fundamental perspective, the wide divergence that has formed between TIPS and fixed-coupon bonds can’t persist forever.

In fact, this week brought about new data from the Bureau of Labor Statistics on widely followed measures of inflation.  Core CPI, which excludes food and energy, rose 2.3% in February in comparison to data released a year ago. For those that may not be familiar with TIPS, their coupon rate is tied to CPI, which in turn increases their payout in an inflationary environment.  Also keep in mind that the Federal Reserve wants inflation back above the 2% mark so they can continue to justify rate increases.

We have been closely monitoring inflation ever since we initiated new holdings in inflation-linked bonds for clients in our Strategic Income Portfolio and subscribers to our Flexible Growth and Income Report.  We believe that at this juncture, TIPS are grossly undervalued relative to other high flying areas of the Treasury market.

For subscribers to our Flexible Growth and Income Report, we initiated a purchase of the Western/Claymore Inflation Linked Opportunities Fund (WIW) last week, to capitalize on a reversal of the wide divergence that has formed between TIPS and fixed coupon treasuries.  In addition, we see view position as a hedge against any unforeseen market volatility in the intermediate-term that could lead to another dip lower in interest rates.

wiw

We opted to go with a CEF in light of a more attractive yield, close tracking margin, and more exotic portfolio management style.  We compared this opportunity closely with a traditional ETF such as the iShares TIPS Bond ETF (TIP) as a reasonable benchmark.

From a strategy perspective, we view this holding as primarily a capital appreciate play as opposed to income, since the yield on WIW is only 3.75%.  Furthermore, we found the expense ratio to be reasonable at 1.11% despite a leverage ratio of 30.73%.  Surprisingly, WIW is also a relatively large fund with a bit over $1 billion in assets under management including leverage from borrowings.

While the fund is no longer below its trailing twelve-month average as I write this, we still view it as an attractive option on a pure underlying asset basis. Furthermore, a trend change is certainly evident in both underlying TIPS securities and a break out above prior consolidation levels in WIW.

Since a typical TIPS portfolio exhibits an effective duration closely mirroring the 7-8-year Treasury bond, we also like owning WIW in case we experience a resumption of selling in risk assets sometime in the second quarter of 2016.  Lastly, even looking at very recent price action, TIPS have been holding up well despite the most recent backup in rates.

Despite years of negative sentiment, we believe that TIPS could begin to quietly shake off their notoriously poor performance, and make a move to ultimately outperform fixed coupon bonds during the intermediate and long-term.

The post Leveraging Our Play on TIPS appeared first on FMD Capital Management.

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