Inflation Protected Bonds

Inflation Protected Bonds

A lot of people are asking me what I think of Bernanke’s testimony before Congress this week. He has been explaining how he is going to deftly remove the 900% increase in bank reserves from the market before it turns into inflation. Here’s my answer.  I have started adding inflation-protected bonds to my portfolio.

When you buy inflation-protected bonds (we call them TIPS in the U.S.) you are basically shorting the central bank. I think that is a good idea today, especially for the U.S.. Here are some ideas how to do it.

For the U.S. you can own IPE and/or TIP. Both are bond portfolios and, therefore, negatively impacted by rising interest rates. The biggest difference is the duration (a measure of the sensitivity of its price to a change in interest rates; you can think of it as the weighted-average maturity.) The duration of IPE is 7.89, roughly double the 4.02 duration of the TIP. That means a one percentage point increase in the level of bond yields, say, from 4.0% to 5.0% will reduce the value of IPE by 7.89% but only reduce the value of TIP by 4.02%.

Another idea is WIP, the exchange traded fund that attempts to reproduce the performance of the non-U.S. inflation-indexed bond sector.  That is important today because the primary inflation risk in the world today is the Fed’s 900% increase in bank reserves since last September. That reserve increase won’t only push U.S. inflation up; it will push the dollar down against the Euro, the yen and other currencies. By owning WIP you own bonds that are protected against inflation in other countries and a drop in the dollar. The duration of WIP is 8.87, which means the bonds are of somewhat longer maturities than the U.S. portfolios above. It is made up of inflation-protected bonds from a number of countries. Its largest holdings are UK (20.4%), France (17.6%), Sweden (5.8%), Canada (5.3%), Italy (5.2%). These are all “museum economies”, places that have become calcified and stopped growing but are still great places to go on vacation to visit the museums.

I like the idea of keeping my equity bets in places that are groaing (China, Singapore, Korea, Brazil, Russia, India) and my (inflation-protected) bond bets in museums. I own all 3 of the stocks I  have discussed above.

Oh, and the Bernanke testimony. The Fed has no chance at all of pu;ing off the maneuvre he talked about this week and sucking nearly a trillion dollars of bank reserves out of the banking system without knocking something over. These are the same idiots who created this mess in the first place.

JR

John Rutledge

2 Comments

  1. Cjeffrey

    July 23, 2009

    I really like this discussion, because it underscores the interrelationship between the federal reserve, the banks and interest rates as well as the ramifications of an easy money policy ! (Lately, it's been easy money for the select few!)

    There are times, and it's usually when I'm unaware that I'm about to stick my foot in my mouth, I tend to view things as existing in a vacuum. So when I read a post like yours, it reminds me that relationships drive the economy. I guess one could extend that idea and say cause and effect drive life. For better or for worse, however, I think a lot of people share my bad habit . Hence the popularity of the phrase, "sh-t happens!"

    I guess this is a long-winded way of asking you a question.

    I was just trying to come up with a way to teach the concept of why TIPS are kind of like car insurance to my 17 year old daughter. The word "car" is definitely a motivating factor right now.

    But trying to come up with an accessible substitute for terms like duration or for ideas like the inverse relationship between price and interest rates is proving to be difficult. Her eyes tend to glaze over rather quickly and she wants to go back to searching for cars.

    You are so good at explaining economic relationships in an easy and accessible manner-- to me and to people like me. I loved the thermodynamics of investing post as well as the discussion of it in your book, primarily because it explains how natural laws can be applied to everything we do. I was wondering, though, how would you get these ideas across to someone who does not have a finance background or who is not educated in these concepts? If you could reach them, you'd have a revolution on your hands.

    Thanks again for all of your insight.

    Christine


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