FEATURED SOLUTION
February 2017
AUTHORS
Mihir Worah
CIO Asset Allocation
and Real Return
Jeremie Banet
Executive Vice President
Portfolio Manager, Real Return
With Inflation Set to
Rise, a Fresh Look at
Active TIPS Strategies
In recent years, many investors have become complacent
about inflation risk on the back of falling commodity
prices and slack in the economy. Now inflation fears
have reemerged as commodity prices recover and the
labor market tightens, while the Trump administration’s
proposed policies – many of which are perceived to be
inflationary – fan the flames. We at PIMCO agree that
inflation risk has risen and see potential for a transition
to a higher inflation regime. With this in mind, it’s
important for investors to contemplate how best to
prepare their portfolios.
Real assets, including Treasury Inflation-Protected
Securities (TIPS), can play an important role by
aiming to mitigate the risks of higher inflation while
also seeking to provide a portfolio with a key source of
diversification relative to traditional stocks and bonds.
Given their explicit link to inflation, TIPS are core to
constructing inflation-fighting portfolios, in our view.
The question becomes how investors can best harness the
potential benefits of these securities.
2
February 2017 Featured Solution
When considering an allocation to TIPS, the natural first step is
to weigh the pros and cons of allocating to an active versus a
passive manager. Both approaches offer potential benefits, costs
and risks. That said, we believe actively managed TIPS
portfolios can add value by seeking to capitalize on market
inefficiencies in ways that passive managers can’t.
UNDERSTANDING INEFFICIENCIES IN THE TIPS MARKET
The TIPS market is characterized by a number of inefficiencies
that present potential hidden costs to passive indexers and
concurrent opportunities to add value for skillful active TIPS
managers. As a result, investors in passively managed TIPS
products may pay more in total execution costs than the fees their
passive managers charge imply. And this potential lost wealth
may be transferred to more flexible active market participants
(including hedge funds and market makers), who may then profit
at the passive investor’s expense. Below we summarize some of
the inefficiencies that may allow this to happen:
On-the-run/off-the-run relative value trading. A TIPS index
includes all TIPS, both recently issued (on-the-run) securities
and existing (off-the-run) securities. As a result, an index may
hold two or more securities with very similar maturities: one
that was just issued and an existing one with roughly the same
time to maturity. A purely passive manager will replicate the
index and hold both issues at index-specified weights. However,
there may be a pricing advantage in holding a higher exposure
to one of the securities and a lower exposure to the other while
still maintaining the same overall duration and curve exposure
as the index.
These possible mispricing scenarios between on-the-run and
off-the-run TIPS create opportunities for active managers to
express relative value views while still maintaining the same key
rate and overall duration as the TIPS index (see Figure 1).
Figure 1: Pricing dislocations between on- and off-the-run TIPS create opportunities
0%
Cumulative return (%)
-1%
Jan '25 TIPS (on-the-run)
Jan '25 TIPS (off-the-run)
New 10-year TIPS
auctioned (Jan '25)
New 10-year TIPS
auctioned (Jul '25)
-2%
-3%
-4%
-5%
-6%
Cumulative excess return
(off-the-run vs. on-the-run, bps)
-7%
100
80
60
40
20
0
-20
Jan '15
Feb '15
Mar '15
Apr '15
May '15
Jun '15
Jul '15
Aug '15
Sep '15
Oct '15
Nov '15
Source: Barclays as of 31 December 2015. Past performance is not a guarantee or a reliable indicator of future results.
Dec '15
February 2017 Featured Solution
Index rebalancing. When new TIPS issues are added to the
index post-auction, or when existing issues drop from the index
as they near maturity, the composition and duration of the
index change. Per index rules, these changes take effect at the
end of the month and are predictable far in advance. Knowing
that rule-following indexers will be buying or selling certain
bonds at month-end, active managers may buy or sell TIPS in
advance and reverse the trade to the indexers at month-end.
Thus the passive investor may end up buying at elevated prices
or selling at depressed prices while still exactly matching the
index’s performance. This presents another potential hidden
cost that passive TIPS investors may repeatedly pay to more
active participants in the market.
Owing to this trading dynamic, TIPS have historically
outperformed nominal Treasuries (richened) in the week
preceding a month-end duration extension of the index (see
Figure 2). For active investors, this recurring structural
inefficiency presents an attractive risk-adjusted opportunity to
add value relative to the passive index.
TIPS auction dynamics. TIPS are issued by the U.S. Treasury
at recurring auctions as part of the government’s overall
funding program. Currently the Treasury conducts monthly
TIPS auctions: three per year for five-year TIPS, six for 10-year
TIPS and three for 30-year TIPS. In 2015, approximately $155
billion of new TIPS were issued through Treasury auctions.
Auctions are key liquidity events for market participants and
consequently tend to create temporary structural distortions in
TIPS valuations. Specifically, TIPS show a recurring pattern of
cheapening in the weeks preceding a TIPS auction and richening
post-auction as the market corrects (see Figure 3). Active TIPS
managers looking to make portfolio adjustments will typically
sell in the weeks before the auction so as not to compete with the
auction supply, thereby driving down TIPS prices pre-auction;
post-auction, the reverse effect occurs. An active TIPS manager
can seek to exploit this recurring structural inefficiency, thereby
adding value versus the passive index.
Figure 3: Active TIPS managers can take advantage of
auction-related inefficiencies
TIPS performance around auctions
1.5
1.0
0.5
0.0
-0.5
-1.0
4
3
2
1
0
-1
-0.2
-0.1
0.0
0.1
0.2
0.3
0.4
0.5
TIPS index extension/contraction (years)
Source: Barclays as of 30 November 2016. TIPS performance
is measured relative to Treasuries, proxied by the Bloomberg
Barclays U.S. TIPS Index relative to the Bloomberg Barclays
U.S. Breakeven Inflation Linked Bonds Total Return Index
(Index matches TIPS index with comparable nominal Treasury
securities). Bloomberg Barclays U.S. TIPS Index is used to
measure index rebalance duration changes. It is not possible
to invest directly in an unmanaged index.
TIPS weaken prior
to auction date...
Auction at T = 0
-2
-3
-4
-5
-6
-1.5
...and strengthen
following auction date
5
Change in 10-year breakeven inflation rate (bps)
TIPS excess return relative to comparable nominal Treasuries
(one week prior to month-end, %)
Figure 2: Mechanical index rebalancing creates flow
dynamics that can be exploited
3
-5
-4
-3
-2
-1
0
1
2
3
Weeks before/after auction
Source: Bloomberg as of 30 November 2016.
4
5
6
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February 2017 Featured Solution
Funding and liquidation costs. Though often overlooked, one
component of the TIPS market structure that may be
particularly costly to passive indexers is the market on close
(MOC) trade order used by passive managers. TIPS indexes use
market close prices to compute their index levels and daily
returns, and MOC orders provide trade executions that nearly
always match these prices. While this benefits passive managers
or Wall Street dealers by reducing their risk of deviating from
the client-specified index, it can be costly for the TIPS investor.
Knowing that passive indexers require end-of-day pricing to
track the TIPS index – which means they will effectively act as
price-indiscriminate buyers or sellers at or near market close –
active market participants will typically richen/cheapen the
TIPS market into the close in order to profit at the indexers’
expense. This can be a significant cost to the passive investor
upon both funding and liquidating TIPS positions.
• Country rotation among inflation-linked bond issuers
By contrast, active managers have a strong incentive to navigate
around the adverse pricing dynamics that tend to occur near
the market close; they instead look for the best intraday
execution by continually assessing liquidity within the TIPS
market. In this way, active managers may potentially provide
more cost-efficient TIPS exposure to their clients, even after
factoring in management fees.
To further enhance potential returns, active managers who are
willing to assume more risk can utilize alternative means to gain
exposure, including the use of inflation swaps. Over recent
history, the inflation swap market has become an efficient
alternative to other transactions for gaining exposure to TIPS
while also providing direct access to trading inflation.
EXPANDING ACTIVE MANAGEMENT TO FURTHER ENHANCE
POTENTIAL RETURN
With U.S. inflation fears likely to mount in the coming years,
investors may contemplate increasing their TIPS allocations –
and a key decision will be how best to obtain that exposure.
Allocating to a skilled active manager with a comprehensive set
of TIPS strategies may enable investors to benefit from
structural inefficiencies in the market and offer fertile ground
for generating after-fee alpha.
Taking advantage of the market’s structural inefficiencies is not
the only way active managers can seek to enhance returns after
fees in TIPS allocations. Active managers of strategies focused
on returns above inflation can also use various means to express
top-down macroeconomic views and bottom-up views specific
to the TIPS and other inflation-linked bond markets:
Top-down strategies include:
• Duration positioning
• Positioning based on views of yield curve
steepening/flattening
• Assessing TIPS’ relative value versus nominal Treasuries,
based on shifts in inflation expectations
• Limited sector rotation among high quality
non-government sectors
Bottom-up strategies include:
• Positioning to exploit seasonal consumer price inflation
(CPI) patterns, which present a recurring opportunity to
capture attractive risk-adjusted incremental return
• “Inflation capture,” or managing the mix of short and long
TIPS to express an active view that CPI will print higher than
the market expects
• Targeted issue selection
• Relative value trading based on the implied option value of
receiving at least the original principal value upon maturity
(i.e., the embedded deflation put)
GOING ACTIVE
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