Bursting The TIPS Bubble (DVY, HDV, IOO)

Russ Koesterich: Call #1: Negative TIPS in the long term; Maintain neutral TIPS in the near term

Recently, investors have been piling into US inflation-linked bonds, or TIPS, as part of their rush to safe-haven assets.

The buying has pushed the real return on TIPS close to negative territory.  In other words, investors have been willing to lock their money up for a decade with the promise of a zero after-inflation return. This makes no sense.

Starting with a bit of history, since the TIPS market was launched in 1997, real yields on 10-Year TIPS have averaged around 2.5%. This is consistent with the long-term historical spread between the yield on the nominal 10-year Treasury and headline inflation. It is also what most of the academic literature suggests is a reasonable real return and is much higher than today’s real yield level.

To be sure, for some investors, current nearly negative real yields are justified due to the anemic nature of the economic recovery. When growth is weak, as it currently is, there is less demand for capital so the price of money drops.

But even when you correct for economic growth, TIPS currently look expensive. Based on the historical relationship between real yields and unemployment, you would expect the yield-to-maturity on the 10-year TIPS to be around 1.10%, not zero. In fact, current real yields are actually suggesting a much more significant collapse in the labor market and an unemployment rate of roughly 12%. This begs the question: Is this a realistic scenario?

While I think the United States will suffer through a prolonged period of slow growth, most evidence still suggests that the United States is not entering a deflationary spiral similar to what has been going on in Japan for most of the past twenty years.

Starting with actual inflation, the path of US inflation looks very different than Japan’s own path a decade ago. In fact, by this point in Japan’s cycle, core inflation was already negative. Whatever is in store for the US economy, deflation appears to be less of a threat.

Second, while there is no lack of bad news for the US economy, there is a difference between a slow recovery and a death spiral. For example, from the peak of Japan’s deflationary spiral in 1990 through 2002, lending by Japanese banks collapsed for a dozen years.

In contrast, while US lending is still weak as consumers are trying to rebuild their balance sheets, it is starting to improve. Bank lending to commercial clients has risen for 10 straight months, and is now 6% above its level a year ago. It will take a long time for banking to return to a more normal environment, but the situation looks much better than it did a year ago.

The bottom line: By piling into US TIPS, investors are driving up prices and driving down yields to a point where these instruments now make little sense for long-term investors. As such, I’m changing my long-term view of TIPS to underweight. Still, I’m keeping my near-term view neutral given the anemic state of the economic recovery and the growing risk aversion in market places.

Call #2: Maintain overweight mega caps

Bonds, in general, are considered less risky than stocks. But I think investors can do better than a zero percent real return. While volatility is likely to stay high in the near term, instead of focusing on TIPS, a better alternative may be to consider focusing on a portfolio of large, dividend paying stocks such as can be accessed through the iShares High Dividend Equity Fund (NYSE:HDV), the iShares Dow Jones Select Dividend Index Fund (NYSE:DVY) or the iShares S&P Global 100 Index Fund (NYSE:IOO).

Disclosure: Author is long IOO and DVY

Source: Bloomberg

TIPS can provide investors a hedge against inflation, as the inflation adjustment feature helps preserve the purchasing power of the investment. Because of this inflation adjustment feature, inflation protected bonds typically have lower yields than conventional fixed rate bonds and will likely decline in price during periods of deflation, which could result in losses. Government backing applies only to government issued securities, not iShares exchange traded funds.

There is no guarantee that dividends will be paid.

Written By Russ Koesterich From The iShares Blog

Russ Koesterich, CFA, is the iShares Global Chief Investment Strategist as well as the Global Head of Investment Strategy for BlackRock Scientific Active Equities. Russ initially joined the firm (originally Barclays Global Investors) in 2005 as a Senior Portfolio Manager in the US Market Neutral Group. Prior to joining BGI, Russ managed several research groups focused on quantitative and top down strategy. Russ began his career at Instinet in New York, where he occupied several positions in research, including Director of Investment Strategy for both US and European research. In addition, Russ served as Chief North American Strategist for State Street Bank in Boston.

Russ holds a JD from Boston College Law School, an MBA from Columbia Business School, and is a holder of the CFA designation. He is also a frequent contributor to the Wall Street Journal, New York Times, Associated Press, as well as CNBC and Bloomberg Television. In 2008, Russ published “The ETF Strategist”(Portfolio Books) focusing on using exchange traded funds to manage risk and return within a portfolio.

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