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TIPS flunk inflation test as fuel, food overtake CPI

Section: Daily Dispatches

By Sandra Hernandez
Bloomberg News Service
Monday, July 7, 2008

NEW YORK -- Treasury Inflation-Protected Securities aren't living up to their name for bond investors who say they can't trust the way the U.S. government calculates the rising cost of consumer goods.

Morgan Stanley, the second-biggest securities firm, and FTN Financial, a unit of Tennessee's largest bank, are telling clients to pare holdings of TIPS, whose principal amount rises with the Labor Department's consumer price index. Morgan Stanley says derivatives tied to inflation expectations are a better bet, while FTN recommends corporate and agency bonds because the index doesn't reflect the actual rate of U.S. inflation.

The $500 billion TIPS market's 5 percent returns this year have beat a 2.2 percent gain for Treasuries, according to Merrill Lynch & Co. indexes. But TIPS should pay more, because the consumer price index downplays the 39 percent increase in gasoline and a 133 percent rise in corn in the past year, investors say. Yields on TIPS relative to Treasury debt, a gauge of traders' inflation bets, barely changed over the past 18 months even as consumer expectations for prices climbed to 3.4 percent, the highest since 1995.

"The consumer price index underestimates inflation," said Jeremy Wolfson, who oversees $8.5 billion as chief investment officer at the City of Los Angeles Department of Water and Power Pension Fund. "Whether TIPS are adding a true inflation hedge, that's arguable based on the CPI component of it."

TIPS pay a lower coupon than Treasuries because investors expect the inflation adjustment on the principal to make up the difference. Traders who expect inflation to increase bet that the gap, or spread, between yields on TIPS and Treasuries will widen. The bigger the so-called break-even rate, the greater traders' expectations that prices will go up.

... 'Barely Budged"

TIPS "haven't paid off" because the break-even rate has "barely budged" over the past 18 months, said George Goncalves, chief Treasury and agency bond strategist with Morgan Stanley in New York.

TIPS due in two or more years show traders see inflation slowing from its current level. In contrast, U.S. consumers expect it to climb to 5.1 percent a year from now, a monthly survey by the University of Michigan showed. Consumer prices rose at a 4.2 percent annual pace through May, more than double the rate as recently as August, according to the Labor Department.

Ten-year TIPS yield 2.61 percentage points less than Treasuries of similar maturity, up 0.31 percentage point since the start of 2007. This year's high of 2.68 percent on March 13 remains below a record of 2.78 percent in March 2005, when inflation increased at a 3.1 percent annual rate. TIPS were first sold by the U.S. government in 1997.

... 'Out Of Favor'

"They have fallen out of favor with us," said Thomas Atteberry, a partner at Los Angeles-based First Pacific Advisors, who manages $3.5 billion in bonds. "CPI understates what's really going on in the economy from an inflation standpoint," he added.

Some analysts say CPI overestimates inflation. The measure overstates changes in living costs by 0.9 percentage point per year, according to a 2003 report by Federal Reserve economists David Lebow and Jeremy Rudd.

Treasuries posted the worst returns since 2004 in the second quarter, losing 2.1 percent before interest, on speculation policy makers will raise borrowing costs this year to curb inflation. The Fed left the benchmark U.S. interest rate unchanged at its June 25 meeting, halting a series of seven cuts since September. Rising energy prices, unemployment, and financial-market "stress" may weigh on the economy, though inflation should "moderate" later this year, Fed officials said.

... 'Not the Answer'

Economic growth probably slowed to 0.5 percent last quarter, based on the median forecast from economists surveyed by Bloomberg on June 12. Inflation will probably fall to 2.9 percent by the first quarter of 2009, a separate survey the same day showed, with projections ranging from 2.4 to 5 percent.

TIPS are "doing better than a lot of things at hedging out that inflation, but it's still not the answer," said William Chepolis, who oversees $9 billion in fixed income at DWS Scudder, a unit of Deutsche Bank AG. "Now the interest has morphed into, 'OK, if I buy a TIPS fund, am I offsetting some of the extra money that I have to lay out at the gas pump or the grocery store?'"

Investors should purchase derivatives that exploit concerns about inflation more efficiently than TIPS, Morgan Stanley advises. So-called swaptions allow investors to buy the right to purchase an inflation swap, in which one party agrees to pay a fixed rate in exchange for the inflation rate. Even if the CPI doesn't immediately rise, the instrument gains value on expectations for future increases.

... Inflation Derivatives

One-year inflation swaptions returned about 0.3 percentage points in April and May, the most recent period for which data is available, according to Morgan Stanley. That compares with a 2 percent loss by TIPS of all maturities, according to Merrill Lynch.

Derivatives are contracts whose value is derived from assets like stocks or linked to events like inflation and the weather. Swaptions are options on interest-rate swaps.

"We've seen pretty good development of the derivatives market and so certainly there's a lot more hedging of inflation with that," said Chris McReynolds, managing director of U.S. dollar inflation trading at Barclays Plc in New York, the biggest TIPS dealer.

Many investors prefer TIPS because they're backed by the government, while derivatives depend on the credit quality of the firm that issues them, he said.

... A 'Cheat'

William Fleckenstein, president of Fleckenstein Capital Inc. in Seattle and co-author of "Greenspan's Bubbles: The Age of Ignorance at the Federal Reserve," isn't one of those investors.

"One reason why I've never owned TIPS is because I knew the CPI was a cheat," he said.

Criticisms of the CPI center on the practice of understating price increases to account for quality improvements in goods like cars and computers. The government also changes the basket of goods it uses to calculate CPI, replacing more expensive products with cheaper ones.

"I figured somewhere along the way people would revolt over these bizarre calculations and maybe someday TIPS would offer some value," Fleckenstein said. "So far they don't."

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