TIPs vs. Treasuries - A Play on Inflation Being Over 0.27% Going Forward

The idea for this came via a friend, and then I looked a bit more into it. Basically the spread between inflation protected US government bonds and standard US government bonds has become extremely small vs. history and even potentially nonsensical, which could be do to panic buying of US government bonds as money has sought a safe haven. Some investors might just have a mandate for plain bonds, rather than TIPs. Or perhaps there still isn't enough liquidity in the TIPs market to accommodate everyone.

As a reminder TIPs are US govt-backed just like standard bonds, plus protect for inflation. The odd thing is that right now, 10-year TIPs have a yield of 2.2%, vs. US 10-year treasuries at 2.47%. This is only a 0.27% spread despite TIPS carrying inflation protection, and means that the standard treasuries are priced as if US inflation will average just  0.27% per year for the next 10 years, which seems highly unlikely. While this market oddity didn't just happen, it nevertheless still exists, thus there could be an interesting opportunity if one were to create a trade based on the expansion of this spread going forward. Something along the lines of short treasuries, long TIPs. 

I am unintentionally Long TIPs and short Treasuries right now, but there is probably a better way to do it than I have unintentionally set up. A spread sheet and some leverage could probably be one method, but given the times this is probably not the most popular way to explain a strategy! So perhaps just be unsophisticated and plain short treasuries.

(Vincent)

Comments

[Andrew Schmitt]

Vincent:

Couple things to be aware of.

1. If there is deflation (negative CPI) the TIPS don't just pay zero, they accumulate a deficit against future interest payments.

2. Do you trust the govt CPI data given how many expenditure increases are tied to it? That worries me.

My primary worry at this point is we enter a period of time where rates go up but inflation goes down. If rates don't go up, the govt will just borrow money and stimulate more until it no longer can (ie rates go up)

[Vincent (The Stalwart)]

Good points. In terms of whether we are going into deflation, ok fair if one believes this, which is basically saying indeed inflation will be less than 0.27% for the next 10 years, as I said I thought was highly unlikely. Then yes, you are correct, then the straight treasuries would be better. But note that TIPs' principal is guaranteed regardless of deflation adjustments. They can only take away your interest.

I see what you're saying with the CPI as well, but standard treasuries won't help you any more on this potential problem. The spread is just 0.27% above the TIPs. Thus even if CPI is under-recorded, as long as it is recorded as 0.27% or more per year, then the TIPs are better.

In terms of inflation falling, even if inflation were lower over the next 10 years vs. the last, it could still easily be more than 0.27% despite being lower, thus again making the TIPs the better deal.

I agree with you on the direction of rates, thats why I think treasuries are bad deals right now, given govt tendencies. Also in relation to this, keep in mind that on the inflation front, its the kind of thing which the US government can have some control over. I think its pretty unanimously understood that the US will have a policy of low inflation rather than deflation. Thus I think your points still indicate the TIPs as better priced relative to standard treasuries. But I admit I did not think about deflation. If indeed someone expected that the next 10 years would be a period of deflation, to the point that 10 year average inflation was below 0.27%, then the standard bonds would be better. I guess the other thing to mention is that a near term deflationary environment could cause people to over-react, sending treasuries to even lower yields even if it was unrealistic that deflation would be long term. But this would only be a problem if your holding period was rather short term.

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Vincent- How do you short treasuries? Do you use an ETF or do you actually short an individual security?

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I guess the other thing to mention is that a near term deflationary environment could cause people to over-react, sending treasuries to even lower yields even if it was unrealistic that deflation would be long term. But this would only be a problem if your holding period was rather short term.

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in my opinion While this market oddity didn't just happen, it nevertheless still exists, thus there could be an interesting opportunity if one were to create a trade based on the expansion of this spread going forward

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Even though I have no clue of the current sentiment, with all the panic going on the drop may last a little longer yet, especially with people being all so negative about the GE.

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But note that TIPs' principal is guaranteed regardless of deflation adjustments. They can only take away your interest.

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