One of the many challenges faced by investors in 2014 is developing a financial asset allocation plan that reflects a realistic assessment of economic realities, can reasonably be expected to offer a return that meets or exceeds one’s financial needs, and does a good job of managing risk. Of course, that is always easier said that done!
A great example of how complex investing can be can be seen within the Treasury Inflation-Indexed Securities markets! These unique fixed income securities (issued by the U.S. Treasury Department) were first introduced at the beginning of 1997, at which point they constituted less than 1.5% of the conventional U.S. Treasury market. They quickly caught on with investors, and within eight years, they accounted for almost 14% of the Treasury market! As the securities developed, they became more commonly referred as “Treasury Inflation-Protected Securities” (TIPS).
What did investors find appealing about TIPS? These securities are intentionally designed to provide a layer of protection against the bond investor’s biggest risk – which is that the impact of rising inflation will cause their bond (paying a fixed rate) to lose “buying power” … something everyone wants to avoid!
Each TIP bond has three important factors: 1) a maturity date (at which time a TIP holder will receive the full amount of their original invested principal); 2) a coupon interest rate that gets paid to the investor twice a year; and 3) principal value that changes; it is raised (or lowered) by the Treasury each month to keep pace with inflation. That third feature is the real “payoff” for TIP investors.
The manner in which this feature is executed is important to understand. The Treasury adjusts the principal of TIPS based upon a two-month lagged value of the non-seasonally adjusted Consumer Price Index for Urban Consumers (CPI-U). Therefore, as inflation rises, the principal value of each TIP should increase accordingly. As an additional bonus, the semi-annual interest payment on each TIP is calculated based upon the inflation-adjusted principal value of that bond at the time of payment – thereby providing an increasing stream of earned interest in the event of an inflationary environment! In those initial years, investors were excited and enthused by this opportunity to get protection against “lost buying power”.
Vanguard Funds provides an excellent illustration of how TIP bonds work (https://personal.vanguard.com/pdf/flgpt.pdf ): [See Slide 1]
The theoretical appeal of TIPS soared following the Financial Crisis in 2007-09, because experts and investors alike have witnessed the mega-growth in Federal Reserve Open Market Operations. The best way to illustrate the unprecedented magnitude of FED Monetary Intervention is to share a graph of the growth in the Federal Reserve Balance Sheet (see Slide 2). This graph comes from the website of the Federal Reserve Bank of Cleveland. Notice that during 2008, the Fed vastly expanded its lending to financial institutions (Gray) – but that “bulge” in lending reverted to a more normal level by 2010. In 2009, the Fed started to inject capital to support key credit markets (Blue), but that largely ebbed by 2011. However, the purchase by the Fed of Agency Debt and Mortgage-Backed Securities (Brown) has been literally mammoth in size – stretching the Fed’s Balance Sheet to well over four times the size at which the Balance Sheet stood in 2007!!!
Most experts concur that any nation whose Central Bank inflates its Balance Sheet to such unprecedented levels will inevitably experience Inflation – eventually! [In fact, one of the goals of the FED in jacking up the Money Supply has been to guard against Deflation.]
In Part II we will review the performance of TIPS in recent years to see how investment “reality” has compared with the compelling theoretical appeal of a bond that protects investors against the negative impact of the inflation that the Federal Reserve appears to be determined to foster!