“TIPS”
TIPS were introduced by the U.S. Treasury in 1997 as a means to protect investors from the effects of inflation. Using the Consumer Price Index (CPI) as a guide, the value of the principal is adjusted at the time of each coupon payment. A fixed interest rate is paid semi-annually on the adjusted amount. At maturity, if inflation has increased the value of the principal, the investor receives the higher value. If deflation has decreased the value, the investor receives the original face amount.
Example: Assume that you invested $1,000 in January on a new 10-year inflation-indexed note paying 3% interest. At mid-year, the CPI indicates that inflation has been 1% during the six months. Your principal is adjusted upward to $1,010 and your interest payment (1/2 of 3%) is based on that figure. Your payment is $15.15. At the end of the year, the index indicates that inflation was 3% which brings the value of your principal to $1,030. Your second interest payment is $15.45 ($1,030 times 3% divided by 2).
Institutional investors who are focused almost completely on the returns of their investments, and who consider the most important measure of risk to be standard deviation, and those other institutional investors who give most of their attention to the value of their assets relative to changes in their liabilities and who consider measures of changes in these asset / liability mismatches to be the best measure of determining risk will find TIPS attractive for the following reasons:
1. They carry a risk which is significantly lower than nominal bonds of
the same duration,
2. The real return of TIPS is known and fixed to maturity,
3. TIPS have an expected return that is equal to, or slightly greater
than, nominal bonds,
4. Depending on the time horizon, TIPS have correlations with nominal
bonds and stocks that are low or negative.
Therefore, for institutional investors who have inflation-linked liabilities (e.g. pension funds, endowments, foundations and nuclear decommissioning trusts), TIPS carry the least amount of risk.
The returns of a TIPS portfolio do not correlate to those of fixed income or equity portfolios, thus making them an attractive addition to an investor's asset allocation. They exhibit the volatility of an equity portfolio while carrying the credit risk of U.S. Treasuries. TIPS portfolios are benchmarked to the Lehman TIPS Index. WCB'S approach is a quasi-index strategy that does not include the use of leverage or derivatives intended to approximate the return of the Lehman TIPS Index.
At WCB, our goal is to construct and actively manage core TIPS portfolios customized to each client’s differing needs as explained above and to provide an incremental return advantage to a client specified core TIPS index (or other performance benchmark) generally by taking the following divergences:
(a) Nominal (non-inflation protected bonds) versus TIPS allocation. Over time our fixed income investment team will generally look to own as many TIPS issues as possible, then determine if nominal Treasuries of similar maturities offer better strategic value. The nominal Treasury allocation is based on valuation models that employ TIPS yields, nominal yields, and expected forward inflation. We also use fair value models that employ crude oil prices, commodity prices, and currency exchange. We do not look to permanently hold nominal securities in lieu of TIPS; rather we hold them only as long as they offer value relative to TIPS.
(b) Allocation along the TIPS yield curve. The amount of each individual TIPS holding is based on the amount of inflation protection each issue provides relative to the underlying nominal Treasury yield curve. Breakeven levels (that is, the difference between TIPS and nominal yields) can vary along the curve and not always in a logical manner. Also, since the TIPS market is growing and evolving rapidly, we factor in new supply of TIPS securities that are periodically auctioned and could impact relative performance of a maturity sector.
(c) TIPS versus CIPS. When pre-approved by clients, WCB may include the use of CIPS, Corporate and U.S. Agency issued inflation protected securities which can provide better protection, and hence better return potential than TIPS. We evaluate the risk-adjusted amount of spread CIPS using an issuer’s nominal credit default swap spreads and stated CPI margin. We also factor in the inherent “deflation put” CIPS possess (principal balance will not decline during deflation unlike certain older TIPS issues).
In the “TIPS” management product, each portfolio is customized and managed separately and in accordance with the investment policies and guidelines as determined by the client.