If we assume that the duration of a 20-year maturity TIPS is 11, then we could estimate that for an increase of just 2 percent in the real interest rate, the price of a 20-year TIPS bond would fall by 22 percent (e.g., -22 percent = -11 x 2 percent). So let’s consider the ratio of reward to risk for this bond. The 20-year TIPS is currently paying 0.15 percent per year (real return) on the reward side of the ledger. But on the risk side, if real interest rates go up by 2 percent tomorrow, then my TIPS bond will fall in price by 22 percent. If your financial advisor has you invested in TIPS bonds, you might want to ask him what his logic is.
A Better Trade
A far better trade is to short TIPS bonds by buying the ETFProShares UltraShort TIPs (TPS). If one felt that they preferred a somewhat more balanced trade, they could short TIPS using symbol TPS and then go long high-yield bonds (under the presumption that we would avoid the two extremes, i.e., a severe recession and a measurable uptick in inflation) using the iShares iBoxx $ High Yield Corporate Bond ETF (HYG). If the investor preferred to be “technically” dollar-neutral they could replace symbol HYG with ProShares Ultra High Yield ETF (UJB). I prefer the simple arbitrage between TIPS and high yield by buying equal portions of TPS and HYG. In any event, until such time as the economic data experiences a remarkably profound change, the short TIPS trade should be prudent and practical.
Rob Brown, PhD, CFA, is chief financial strategist for Eqis Capital Management Inc. in San Rafael, Calif. You can reach him at [email protected]. All economic and capital market data was provided by Ned Davis Research of Atlanta, Ga., and was the most recent data available as of January 2.