Pimco, Invesco find value in TIPS with dormant CPI
At a time when the bond market expects inflation to stay at about the past decade’s average, the biggest buyers of government debt say they need protection from rising consumer prices as central banks focus on growth.
Pacific Investment Management Co. and Invesco Ltd. say growing central-bank tolerance of inflation means securities with interest or principal tied to consumer prices are the ones to own. Global expectations indicated by the gap between yields on so-called linkers and government bonds reached a 21month high of 1.70 percent, Bank of America Merrill Lynch indexes show. Economists in Bloomberg surveys forecast consumerprice gains of 2.72% in 2013, in line with the 10-year average.
After four years of stimulating economies, central bankers are starting to see signs of accelerating growth, spurring some bond investors to prepare for a rise in yields from record lows. Index-linked securities are favored because sovereign-debt returns are being erased by what little inflation there is.
“There’s an element of central banks, whether they say it or not, being more relaxed about allowing inflation to rise,” Paul Mueller, a London-based fund manager at Invesco Asset Management, a unit of Invesco Ltd., which manages $713 billion, said in a telephone interview February 19. “While I don’t think we are going to see inflation escaping to very high levels, it does make sense to have protection.”
Global stimulus
Policy makers from central bank including the US Federal Reserve, the Bank of England and the Bank of Japan pumped more than $3.5 trillion into economies to stimulate growth during the five years following the start of the deepest global slump since World War II. Global gross domestic product will expand almost 2.4% this year, from 2.2% in 2012, a Bloomberg composite of economist estimates shows, increasing speculation that inflation will also start rising.
Investors seeking insurance against future price rises have helped inflation-protected issues in developed markets outperform regular securities by 0.25 percentage points this year through February 20, according to Pimco indexes. Linkers have beaten nonindexed bonds in the UK, Japan, Germany, Italy, Sweden, Australia and New Zealand.
Securities with maturities of 10 years or more across the G-10, except Japan, are losing out to shorter-dated debt as investors demand more compensation for the risk of inflation, according to indexes compiled by Bloomberg and the European Federation of Financial Analysts Societies.
Bond yields
US Treasury Inflation-Protected Securities, or TIPS, have lost 1.32% this year as Treasuries declined 1.3%, according to the Barclays US Inflation-Linked Bond index and the Barclays US Government Comparator Bond Index, which is adjusted to reflect the longer duration of TIPS. They returned 7.26% in 2012, compared with 3.3% for the duration-adjusted government bond index.
Yields on US 10-year notes dropped last week by four basis points to 1.96% amid speculation the Fed’s asset purchases may support bond prices, according to Bloomberg Bond Trader data. The benchmark 2% note CLERKS REVIEW buy and sell orders outside the two- and five-year US Treasury Note options pit at the Chicago Board of Trade in Chicago. Yields on US 10-year notes dropped last week by four basis points to 1.96 percent amid speculation the Fed’s asset purchases may support bond prices. due in February 2023 rose 11/32, or $3.44 per $1,000 face amount, to 100 10/32. The yield on 10-year TIPS due January 2023 dropped on the week to negative 0.57%.
Ten-year notes yielded 1.98%, and the TIPS rate was negative 0.56% as of 08:10 a.m. in New York on Monday.
BlackRock picks
“One should be looking to own inflationlinked bonds rather than nominal bonds, and that argument is more compelling the further out of the curve you go,” Martin Hegarty, the co-head of BlackRock Inc.’s inflation-linked bond funds, which holds more than $28b. of assets, said in a telephone interview February 20.
Hegarty, whose company oversees $3.8t. as the world’s largest money manager, favors inflation-linked debt with three- to sevenyear maturities in Germany, Italy and the UK. He is also buying TIPS with maturities of one to two years, even though BlackRock doesn’t anticipate any immediate jump in consumer prices unless there is a surge in energy costs.
The global breakeven rate, a measure of inflation expectations, is at 1.64 percentage points, compared with a 10-year average of 1.2 percentage points and a peak of 2.14 percentage points in July 2008, Bank of America Merrill Lynch indexes show.
The breakeven rate in the US was as high as 2.61 percentage points this month, from 2.24 percentage points September 4. It rose to 2.73% on September 17, four days after the Fed announced an open-ended bond-buying plan to keep pumping funds into the financial system, the highest since May 2006. The central bank announced the additional Treasury purchase program of $45b. per month on December 12.
‘Good time’
“It’s a good time to seek inflation protection,” Craig Veysey, the head of fixed income at Sanlam Private Investments Ltd. in London, part of the Sanlam Group, which oversees $72b. of assets, said by phone February 12. “Central banks, which for years have been trying to keep inflation at a relatively low level, now understand they need to do much more. I’m not saying inflation is likely to rise sharply. The market has not sufficiently priced in the risk.”
US consumer prices rose 1.6% in January from a year earlier, the Labor Department reported February 21. Inflation averaged 2.5% over the past decade.
The Treasury sold $9b. of 30-year TIPS February 21. Indirect bidders, a gauge of demand from overseas buyers, bought 54.5% of the issue, the second-biggest share on record going back to 2001, according to data compiled by Bloomberg.
Under pressure
With economies still failing to shrink debt and grapple with above-average unemployment, growth and inflation are likely to stay subdued, according to Aaron Kohli, an interest-rate strategist in New York at BNP Paribas SA, one of 21 primary dealers that trade with the Fed. The US economy contracted in the fourth quarter, while Japan and the 17nation euro area extended recessions.
“Breakeven rates may come under pressure again if risk appetite falters,” Anton Heese, the global head of inflation strategy at Morgan Stanley in London, said by phone on February 13. “My impression is that a lot of investors lack conviction on the recovery we are seeing at present. The output gap in the economy is still substantial. Therefore, there is potential for growth to pick up with inflation remaining subdued.”
‘One should be looking to own inflation-linked bonds
rather than nominal bonds, and that argument is more compelling the further out of the curve you go’
Target rate The Fed cut its benchmark overnight bank lending rate from 5.25% in September 2007 to a record low of zero to 0.25% in December 2008. It began buying $1.7t. in mortgages, Treasuries and agency debt to encourage new bank lending in 2008, followed by a $600b. second round of Treasury purchases in November 2010. Operation Twist in September 2011 replaced $667b. in short-term bonds with longer-maturity issues.
The central bank is now buying $85b. of mortgages and Treasuries each month to underpin the economy and reduce the 7.9% unemployment rate. Its balance sheet topped $3t. for the first time last month.
Policy makers said in December they would hold interest rates at about zero so long as projected inflation stays at 2.5% or less and unemployment remains above 6.5%. The jobless rate was 7.9% in January, government data show.
Investors should buy TIPS because the Fed’s policies will eventually fuel inflation, according to Bill Gross, co-chief investment officer at Pimco, which runs the world’s biggest bond fund. “We’re not inflationary hawks in 2013. We simply think because central banks are writing trillions of dollars worth of checks, ultimately that will produce the desired inflation they are targeting,” he said in a telephone interview February 22.
International linkers
Gross said he owns 10-year and 15-year TIPS that reflect inflation expectations for 2020 and 2025, as well as New Zealand and Mexican linkers. He sees US inflation at 2% this year and 2.5% for the three years after that.
While the Bank of England’s 2% inflation target was breached for the 38th consecutive month in January, Governor Mervyn King said February 13 that central-bank officials will keep encouraging growth. The latest minutes of its policy meeting, published February 20, said further asset purchases “could help the process of rebalancing the economy.”
The BOE said in July that the £200b. ($305b.) spent on bond purchases from March 2009 to January 2010 increased output by as much as 2% and inflation by 1.5 percentage point.
‘Kitchen sink’
In Japan, the central bank raised its inflation target to 2% in January from 1%. New Prime Minister Shinzo Abe campaigned on promises of more monetary stimulus and weakening the yen, which has dropped 17% against the dollar since October 1, its worst performance over a similar period since 1985.
“Central banks have made it even clearer they are not prepared to tolerate anything less than inflation,” Neil Williams, chief economist at Hermes Fund Managers, which oversees $42b. of assets, said in an interview February 14. “That means they will throw a kitchen sink at it in terms of liquidity injections.”
The value of global equities surged $6.5t. since mid-November, with the Standard & Poor’s 500 index reaching a five-year high. The Stoxx Europe 600 Index rose 12% since European Central Bank President Mario Draghi pledged July 26 to do “whatever it takes” to safeguard the monetary union.
Several policy makers said the Fed should be ready to vary the pace of monthly bond purchases, according to the minutes of the Federal Open Market Committee’s January 29-30 meeting. They review the program March 19-20.
“The Fed is more tolerant of higher inflation outcomes in order to work on the other side of their mandate” to cut unemployment, Michael Pond, head of global inflation-linked research in New York at primary dealer Barclays Plc, said by phone on February 21. “Inflation-linked securities offer very cheap insurance because if the Fed is going to get it wrong, they are going to get it wrong on the side of leaving accommodation longer rather than risking removing it too early.” (Bloomberg)