Description

Short TIP etf w/ a hedge!

3/4 of the inflation protected treasury bonds inside the popular Blackrock TIP etf were issued before the post-covid inflationary period. These bonds have been adjusted up to reflect this inflationary period. I am not making a call about inflation or deflation but if there is deflation these bonds will be adjusted back down such that today’s investor in the TIP etf will receive less than purchase price.  

Deflation happens.  No one is expecting it right now but if you zoom out you’ll see that we had a severe, decade-long bout with deflation in the 1920s. 

Exhibit 1:  source: https://advisor.visualcapitalist.com/inflation-over-last-100-years/

So the real message here is why take deflation risk if you don’t have to?

HISTORY:

TIPS bonds came out in the late 90s as an alternative to regular treasury bonds.  Unlike treasury bonds, the face value of the TIPS bond is adjusted to reflect inflation.  Inflation or deflation, investors will get at least $1000 back at maturity.  As the value is adjusted, the coupon is adjusted.  Said another way, the coupon rate stays the same but since the face changes with inflation the coupon payment changes, too.  Most of the time we have mild inflation.  For the last 50+ years nothing other than mild inflation has really been considered.  

Each TIPS bond has a unique, evolving inflation factor that keeps track of how much inflation that particular bond has experienced.  It is really not a fancy number to figure out.  It is based on CPI.  You can verify the number by running the issue date through a calculator like this and comparing it to the reported inflation factor.  

Exhibit 2:  https://www.bls.gov/data/inflation_calculator.htm

The nice people at Blackrock only report the price of the individual TIPS bonds.  When you get a quote on Bloomberg, price is all you get, as well. Price by itself is irrelevant.  The price is not what Blackrock would receive if they sold the bond and this quoted price isn’t what new investors are paying when they buy the etf.   The bond trades at the price multiplied by the inflation adjustment.

Here is the Blackrock TIP etf portfolio with inflation adjustments, sorted from least adjusted to most adjusted:

Exhibit 3:  https://www.blackrock.com/us/financial-professionals/products/239467/?referrer=tickerSearch

Inflation Adjustment Factor from Bloomberg

Upon maturity holders of these bonds will receive the inflation adjusted value (multiplied by 1000) as long as it is above 1000.  Unlike regular treasury bonds, you can lose money buying TIPS bonds on the secondary market because you pay the inflation adjustment factor multiplied by price. If there is deflation after purchase, the adjustment number gets smaller.  The first dozen or so bonds barely have any inflation adjustment in them so they are relatively safe from deflationary risk.  The remaining 75% of the bonds have a lot to give up if there is deflation.

The Trade:

I recommend shorting this TIP etf and buying a specific, recently issued TIPS bond, like cusip 91282CGW5 that comes due on 4/15/2028. This bond is actually the bond with the lowest inflation factor in the TIP etf portfolio.  The inflation adjustment factor is barely above 1.  Even if there is massive deflation, this particular TIPS bond cannot deliver negative returns upon maturity while the TIP etf as a whole could deliver negative nominal returns over the same period.  If there is inflation the returns of the TIPS bond should be as good or better as you have no expense fee in direct ownership.  It is also less sensitive to interest rates (assuming that inflation will continue to bring higher interest rates).

I was going to write this up as just “buy this particular bond” then I thought that a 1.8% real return is just not sexy enough for the VIC crowd.  Someone wrote up ibonds so at the very least this writeup compliments that writeup.  Or maybe this will convince some asset-allocator type to toss the TIP etf from the mix because of the deflation risk that one doesn’t need to take with careful security selection.

To better illustrate this trade of long “low inflation factor” vs. “short high inflation factor,” let’s look at 3 similar TIPS bonds available on Fidelity:

Exhibit 4:  3 TIPS bonds coming due in 2028 available at Fidelity.  The top and bottom have a lot of baked-in inflation.  

I recommend the middle one as a long vs the TIP etf as a short. Think of the TIP etf as a portfolio that mostly contains bonds like #1 (top) and #3 (bottom).  I don’t think you’re getting enough extra compensation to buy the top one.  I can’t figure out why anyone would buy the bottom one.

Exhibit 5:  YTM of 3 different bonds depending on inflation. So if inflation is ~2% per year over the next 5 years, your return for buying any one of the TIPS bonds or the plain treasury bond will be roughly the same, roughly 4% per year.  If we have severe deflation then you will still make 1.4% if you hold the recommended bond until maturity.  You will experience a loss in the other 2 TIPS bonds.

The 2028 bond I recommend in this writeup has a shorter duration (~4) than the TIP etf (6.7) so it will be less sensitive to interest rate movements.   If you don’t like that mismatch then blend in the number 2 bond on the full portfolio list, cusip 91282CGK1, coming due in 2033. 

Realistically, if we have deflation regular treasuries will trade down to 1 or 2% matching the yield to 2028 tips bond I recommend.  I don’t think you’ll face any significant price risk either way.

Last but not least:

“When the VIX is high, TIP etf must die!”  For a completely different reason to short TIP, look at the long term chart.  What a big wimp this TIP thing is! Whenever something bad happens (GFC, Covid) it drops like panties on prom night.  It is like the anti-VIX.  When the vix is high (>30) the average monthly return for TIP is negative .5%.  Regular government bonds are positive .5%.  Is it worth it?  The total return over the last decade has been a wimpy 1.57% per year.  Normally, one accepts low gov’t bond returns for protection & liquidity.  Most embarrassing for TIP etf is the return over the last 2 years - it was negative despite record high inflation!  What a disappointment!

Which leads me to the real (pun intended) truth:  Inflation or not, the U.S. cannot handle inflation because we can’t handle higher interest rates. The bozos that count inflation are working for the deep state Sith Lords that must maintain the  status quo at all costs. Whether you look at the yield curve, inflation expectations, or just ask anyone on the street:  the current interest rate situation is temporary.  We simply cannot accept the idea that inflation may remain high and rates higher because, as everyone knows, our economy is built around cheap money.  Therefore CPI manipulation must continue.  CPI will drop.  Even when the CPI print was 10%, the stuff we buy actually costs much, much more.  I challenge you to find something useful that only went up 10% in price over the last couple of years - yet there it was, a measly 10% print.

Catalyst

Deflation