Mihir Worah Executive Vice President PIMCO	Bob Greer Executive Vice President PIMCO

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Mihir Worah and Bob Greer of PIMCO discuss the recent underperformance of TIPS and why they believe the outlook is attractive for this asset class going forward.

TIPS underperformed in recent months

In the last two months Treasury Inflation-Protected Securities (TIPS) have suffered steep price declines compared to nominal Treasuries. This year, through August, Barclays Capital U.S. TIPS Index was positive. But it declined by 3.83% in September, and a further 8.69% in October. This negative return is not limited to U.S. TIPS. Barclays Capital Global Inflation-Linked Bond Index, for instance, declined by 3.23% in September, and a further 6.63% in October.

For comparison, the Barclays Capital U.S. Treasury Index returned 0.61% in September and -0.11% in October. Real yields on 10-year TIPS on November 13 were 2.91%, compared to a nominal yield of 3.76% on the 10-year Treasury. The difference in these two rates, called “breakeven inflation (BEI),” is the rate of inflation that would have to occur over the next 10 years for these two bonds to provide the same total return. That BEI was a very low 0.85%.

Why TIPS suffered more than nominal Treasuries

October was the single worst month for TIPS since they were first issued in January 1997. There were a couple of factors causing this. The major fundamental factor was reduced inflation expectations leading to reduced demand for inflation protection. Another factor was a flight to quality and to liquidity.

It's no secret that financial markets are going through a global “delevering.” Risky assets are being sold—by choice or because the sale is forced. To the extent that sale proceeds are being reinvested, they are going to markets that not only are less risky (a flight to quality), but also more liquid (a flight to liquidity). And nominal Treasuries are much more liquid than TIPS.

This delevering accompanied a developing global recession, and expectations of that recession led the markets to expect a reduced demand for goods and services. This in turn is causing lower commodity prices, which has caused us to expect lower inflation. If you are expecting lower inflation, you have less need for TIPS and more desire for the greater liquidity of nominals.

The other important factor that has affected TIPS markets is that some hedge funds, especially equity hedge funds, bought TIPS as a substitute for buying crude oil futures. That's because there has been an increasing correlation between these two assets. Now many of those hedge funds are delevering, and also expectations for crude oil prices have been lowered. So as this trade has been unwound, it has caused additional selling of TIPS.

Near-term outlook for lower inflation

Our expectation is that inflation, the U.S. CPI, will come down over the next year. Headline inflation has been pumped up by food and energy prices, so that the latest numbers, released in mid-August, showed a year-on-year inflation of 4.9%, compared to 5.4% year-on-year reported a month ago. So inflation is starting to decline already. The decreases we have seen in energy prices will work their way through the rest of the CPI, for the most part, over the next few months. Decreases in grain prices take close to a year to be fully realized in the food component of the CPI, so the grain price declines we have experienced since summer will continue to exert downward surprising to see headline inflation at some point in 2009 below 1%, and the non-seasonally adjusted CPI might even briefly be negative.

Inflation should increase over secular time frame

Beyond the current severe economic weakness and drop in commodity prices, however, we are sowing the seeds for renewed inflation over our secular time frame. As Bill Gross said in his October Investment Outlook, “Expect a lengthy recession, but not a depression, accelerating government deficits … and the eventual rise of inflation.” The drivers of renewed inflation include:

• Central banks providing liquidity, which is currently not making its way into the broader economy, though that is the goal and will be the eventual result. These banks explicitly want to reinflate our economies.
• Currently, central banks can raise money by issuing Treasuries, since that is what investors want. But if that ends, then the Treasury may simply have to turn on the printing presses.
• The drop in commodity prices is causing producers to delay plans for the expansion of supply that will be needed as the global economy recovers. This creates the potential for the kind of imbalance of demand over supply that we saw from 2006 through the first half of 2008.

So we expect inflation to moderate over the near term, but to be a renewed and potentially even more serious problem over the secular time frame. What does this say about TIPS valuations?

1. Relative to nominal Treasuries, we believe TIPS currently represent better value. Specifically, given our longer term view of inflationary pressures, we favor longer-dated TIPS. We don't expect inflation to be as low as implied by the current breakevens. Those BEIs, we believe, are driven more by technical factors than by a radical change in inflation outlook.
2. On an absolute basis, real yields of about 3% are attractive given the low level of credit risk in holding TIPS. Over a long period of time, nominal Treasuries have seldom offered yields that, in real terms, were above 3%. And in the 11 1/2-year history of TIPS, that level of real yields was seen up to 2000 and seldom since.

Strategies currently used in TIPS portfolios

Our strategies can best be described as maintaining liquidity, holding many of our non-TIPS views while not adding to those positions, and taking advantage of the mispricing of TIPS due to technical factors. We have recently moved from an underweight TIPS duration to an overweight TIPS duration, with an emphasis on longer maturity TIPS. Beyond those themes, our portfolios are staying pretty close to their benchmarks in currency exposure and other risk measures. While these allocations may have detracted somewhat from relative performance recently, we nonetheless expect these allocations to begin to add value as markets start to normalize.

PIMCO Real Return Fund performance

Over the longer term, TIPS have provided value to our portfolios. And over the longer term, say three or five years, the A Shares of the PIMCO Real Return Fund have come close to the index after fees. But recently, as TIPS declined in value, so did our performance relative to the index.

The main reason for this performance was that we took positions in non-TIPS sectors when we thought they represented great value. This was most obvious in our purchases of debt issued by financial institutions, and also our purchases of agency-backed mortgages. As you have heard Bill Gross and others say, while we still like much of that paper, we were early in our purchases, and many of those assets have been written down on a mark-to-market basis.