No Strategic Reason to Own Nominal Bonds Now

By: Michael Ashton | Tue, Jan 26, 2016
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Today I presented our 2016 inflation forecast to the investment committee for a multifamily office, and when I was putting the presentation together I developed one slide that really is a must-see for investors in my opinion.

For some time, TIPS have been too cheap. Really, it has been more than a year that our metrics have shown inflation-linked bonds as not just cheap, but really cheap compared to nominal bonds. I don't mean that real yields will fall - so this isn't a statement about whether I am bullish or bearish on fixed-income. Frankly, I am somewhat conflicted on that point at this moment.

Rather, it is a statement about what sort of fixed-income instruments to own, for that part of your portfolio that needs to be in fixed-income. If you are running a diversified portfolio, then you can't really avoid owning some bonds even if you are bearish on the bond market. For risk-reduction reasons if for no other, it makes sense to own some bonds.

But you don't have to own fixed-coupon nominal bonds (or, for that matter, floating-coupon nominal bonds which are still exposed to inflation through the principal of the instrument). In fact, right now it is hard for me to imagine betting on nominal bonds for the portion of my portfolio that is in fixed-income.

A picture is worth a thousand words, so here is the picture:

10-Year Compounded Inflation 1881-2016

The chart shows rolling, compounded 10-year inflation rates for as far back as we have reasonable data. And it shows the current level of 10-year inflation "breakevens." What this means is that if you are long Treasuries, rather than TIPS, you will do better over the next ten years if inflation is below 1.34% and above roughly zero. If we have big deflation, TIPS will do just about as well since they are also principal protected; if we have any inflation over 1.34%, TIPS will do better.

And as the chart points out, since the Fed has been formed we have literally had almost zero 10-year periods in which inflation was in the 0-1.34% zone. Perhaps the 10-year periods ending early in the Great Depression, en route to big deflation, or coming out of the Great Depression heading into WWII. But otherwise, inflation has always been either higher or, in a Fed-screw-up scenario, much lower.

Put another way, it means that if you choose to own nominal bonds instead of inflation-linked bonds for the next 10 years, you are short a straddle on inflation, and you're not being paid much to be short it. (Technically, you're short a zero-cost ratio call spread since you don't lose in deflation, but I'm trying to keep it simple!)

There may be tactical reasons to prefer nominal bonds to inflation-linked bonds. But to me, there is no clear strategic reason to be long nominal bonds for that portion of your portfolio that you intend to keep in fixed-income.

 


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Michael Ashton

Author: Michael Ashton

Michael Ashton, CFA
E-Piphany

Michael Ashton

Michael Ashton is Managing Principal at Enduring Investments LLC, a specialty consulting and investment management boutique that offers focused inflation-market expertise. He may be contacted through that site. He is on Twitter at @inflation_guy

Prior to founding Enduring Investments, Mr. Ashton worked as a trader, strategist, and salesman during a 20-year Wall Street career that included tours of duty at Deutsche Bank, Bankers Trust, Barclays Capital, and J.P. Morgan.

Since 2003 he has played an integral role in developing the U.S. inflation derivatives markets and is widely viewed as a premier subject matter expert on inflation products and inflation trading. While at Barclays, he traded the first interbank U.S. CPI swaps. He was primarily responsible for the creation of the CPI Futures contract that the Chicago Mercantile Exchange listed in February 2004 and was the lead market maker for that contract. Mr. Ashton has written extensively about the use of inflation-indexed products for hedging real exposures, including papers and book chapters on "Inflation and Commodities," "The Real-Feel Inflation Rate," "Hedging Post-Retirement Medical Liabilities," and "Liability-Driven Investment For Individuals." He frequently speaks in front of professional and retail audiences, both large and small. He runs the Inflation-Indexed Investing Association.

For many years, Mr. Ashton has written frequent market commentary, sometimes for client distribution and more recently for wider public dissemination. Mr. Ashton received a Bachelor of Arts degree in Economics from Trinity University in 1990 and was awarded his CFA charter in 2001.

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