Mar 23, 2017 | Post by: Roman Chuyan, CFA Comments Off on TIPS and Tactical Investing

TIPS and Tactical Investing

  • I begin with an overview of tactical investing applied to fixed income.
  • TIPS recommendation is reiterated.
  • The available TIPS products are compared.

In last week's article, I wrote that Treasury inflation-protected securities became attractive. Our model made this recommendation based on the level of 10-year real yield (60 basis points at the time) and its recent trend. Today, I will compare the securities that give investors exposure to the TIPS market. But first, let me step back and describe what we are doing with our Tactical Income strategy.

A Tactical Approach to Fixed Income

First, the big picture. The theory says that passive investors are supposed to hold a market portfolio, which means holding one or more indexes. There's nothing wrong with it – it's a low-cost, low-maintenance strategy that works for many investors. Applied to fixed income, a passive approach might mean buying a popular bond index such as the Barclays U.S. Aggregate (AGG, BND). An investor who bought it in the past 5 years locked-in a yield below 2% on the original investment. If market yield rises to 3% or 4%, it's not (yet) a problem for the buy-and-hold investor. The problem begins when he/she wants the higher yield. He can't get it – he is “stuck” with 2% until maturity. If the investor wants the higher yield, he has to sell, realize a capital loss, then earn the higher yield on the lower amount – which will give him roughly the same IRR in the end. (It's a bit different for funds vs. individual bonds, but that's the idea.)

Active investors attempt to do better than passive. A version of active investing, tactical management (or tactical asset allocation) means altering allocations periodically to maximize expected return. Our Tactical Income strategy applies it to fixed income. We scan the universe of fixed-income asset classes to find those with the best combination of expected return and risk.

This long-term chart shows the 30-plus year bull market in bonds as interest rates fell since 1982. Bond investors “had it easy” during these decades, with high interest rates and price gains from falling rates. With the double bottom in 2012 and 2016 around 1.5% for the 10-year Treasury, the bull market has probably ended. My point here is that in the coming years, periods of gains/higher returns will likely be mixed with periods of low or negative returns. In such an environment, tactical approach to fixed income investing may be more relevant than ever.

TIPS Recommendation

February CPI inflation, reported last week, rose to 2.7% from 2.5% last month:

The Fed announced their decision to raise the funds rate last Wednesday. The market reaction was counterintuitive but perhaps not unexpected: longer rates dropped and bond prices jumped on that day, including TIPS.  But the price is still in the middle of the range of the past 12 months.

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TIPS pay interest adjusted for CPI inflation – for more on their “mechanics” please see my December article. With inflation now at 2.74% and 0.45% coupon, TIPS provide 3.2% (2.74% + 0.45%) gross nominal yield to maturity. This far exceeds 2.4% on nominal 10-year Treasury notes; and again, TIPS offer inflation protection, which fixed-rate bonds don't.

The caveat “in the near term” is important – it will vary with changing TIPS prices and inflation. With core inflation at 2.2%, total inflation may not persist as high as it is now at 2.7% – more on this in another article, so stay tuned.

Which TIPS?

There are two ETFs which provide exposure to the broad TIPS market: iShares (TIP), and Schwab's (SCHP). I'm excluding from discussion 1-5 year TIPS products that have shorter duration, are less liquid and offer much lower real yield.

SCHP is smaller of the two, but has grown in the past couple of years, partly due to its lower expense ratio, only 7 bps compared to TIP's 20 bps. But it comes at a cost of wider bid-ask spread of 5-10 bps in a normal market – and I saw it wider than 20 bps in the “fast” market on the day of the Fed meeting. All things considered, I would give preference to SCHP, especially if you hold your account at Schwab, so you can trade it commission-free. However, if your holding period is short or you manage significant assets, I would go with TIP for liquidity reasons.

Disclosures: We are long TIP and SCHP. Roman Chuyan is the president and general partner of Model Capital Management LLC, a Registered Investment Adviser. This article is for informational purposes only. There are risks involved in investing, including loss of principal. Roman Chuyan makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by him or Model Capital Management LLC. There is no guarantee that the goals of the strategies discussed in this article will be met. Information or opinions expressed may change without notice, and should not be considered recommendations to buy or sell any security. Asset allocation, tactical asset allocation, TAA, tactical investing, tactical management, ETF, tactical investment management, Financial planning systems for advisors, Financial planning tools for advisors, Financial planning tool for advisors. Envestnet, TD Ameritrade, Adhesion, Best TAMP, SEI Advisor Network, Schwab intelligent portfolios. Betterment institutional, Schwab PortfolioServices, Dynamic wealth advisors. Investor onboarding, Financial planning platforms, Client onboarding for wealth firms, investment management for WM. Investment management for advisors, Schwab performance technologies, SEI Advisor, Ameritrade Adhesion, Best TAMPs. Investment management platform, SEI Asset Management, Schwab Portfolio Services, Investment management platforms. Schwab Portfolio Center, AssetMark, Financial planning system for advisors, Orion Advisor, SEI Practice Management, client onboarding for WM. Financial planning software for advisors, Robo plus, Financial planning platform. Turnkey asset management platform, client onboarding wealth management, SEI Advisor Center, Orion Advisor Solutions, Schwab PortfolioCenter. Robo advisors plus, SchwabPT, Adhesion Wealth, investment management for advisor. Client onboarding for wealth, Turnkey asset management platforms, investment management for advisory, Schwab intelligent portfolio.

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