Who Owns TIPS and Why Should it Matter to Investors?
Treasury Inflation Protected Securities (TIPS) are Treasury quality bonds with an inflation hedge. We believe that many investors see TIPS as an almost perfect solution to their concerns about inflation during this period of easy monetary policy; however certain characteristics of the TIPS marketplace lead to risks which may come as a surprise to investors. TIPS buyers should be aware of how the Federal Reserve’s bond buying program and the role of mutual funds may affect the value of their holdings. The presence of such large players has the potential to impact market liquidity and investors should carefully consider the high interest rate risk in TIPS mutual funds/exchange traded funds.
The Federal Reserve has expanded its balance sheet from approximately $1 trillion before the financial crisis to over $3.3 trillion today. With its main policy rate near zero since 2008, the Fed has engaged in quantitative easing to keep interest rates low and financial conditions accommodative. Policymakers contend that buying bonds (Treasuries, TIPS, agencies, agency MBS) provides meaningful support to economic growth in the face of high unemployment, fiscal headwinds, and Eurozone turmoil. As Chairman Bernanke stated on May 22, 2013, the potential risks include asset bubbles caused by a “reach for yield,” inflation, and the malfunctioning of securities markets. The Fed says it is monitoring these risks, but believes the benefits outweigh the costs.
As we noted in our First Quarter High Grade Core Intermediate commentary, we do not place Treasury bonds in the bubble category, but neither do we think they represent good value at today’s prices. We have, however, turned a favorable eye on TIPS given their relative value and diversification benefits. Even so, we believe conservative investors should be aware of the evolving landscape of this market before deciding the best way to invest.
The Fed owned approximately $80 billion of TIPS at the end of April 2013, representing 10% of the investable market. On the surface, we believe this appears to be a manageable amount. Table 1 shows how much of the outstanding market is owned by some major players, sorted by maturity date. As communicated to the market, the Fed concentrated its buying in longer maturity bonds to achieve its objectives. This has resulted in the Fed owning over 34% of all issues maturing after 20 years. Short and intermediate maturities are less dominated by the Fed.
What investors may not know is the role of large institutional money managers in the TIPS market. The four managers shown in the table above own 18% of the total amount outstanding through various managed mutual funds and exchange traded funds. Including the Fed’s 10% position in the market, these five players own 28% of outstanding TIPS. The numbers are even more striking when one analyzes individual issues. Table 2 shows the outstanding bonds with over 10 years to maturity. The five players discussed own more than 46% of these bonds but their ownership ranges from 17% to 59% of any given issue. This detailed market structure data complements the fundamental analysis by identifying those issues whose price may be affected by the actions of these large players.
TIPS investors buying issues (either individually or through mutual funds/ETFS) owned by these large players may be unwittingly caught between actors with differing mandates. The Fed uses bond buying to ease financial conditions by keeping long term rates low and its participation in the market is subject to change given economic conditions. Many institutional money managers, on the other hand, are benchmarked against indices that are meant to reflect the broad market. As a result, TIPS funds own longer maturity bonds to best match the index.
The implication for investors is twofold: First, if the Fed changes course and begins selling, those issues with high percentages could be hit hardest. The same is true if a particular fund company was forced to raise funds, particularly during a deflationary scare as investors rushed to the exits. Second, the long maturities mean high interest rate risk. TIPS principal amount adjusts upward with inflation, but these are still fixed rate securities that can lose money between purchase and maturity. The rate risk inherent in TIPS mutual funds means that the inflation protection investors seek may be more than offset by interest rate risk in a rising rate environment.
It is difficult to predict when the Fed will unwind its bond buying program or when market sentiment will change and force particular mutual funds to sell holdings to redeem shares. However, investors interested in TIPS can still take action to minimize their exposure to the risk of these developments by purchasing them in separately managed accounts rather than mutual funds and focusing on intermediate maturities to minimize interest rate risk. This would allow them to avoid issues that are likely to be affected by involvement from major actors.
May 23, 2013
Any statements regarding future events constitute only subjective views or beliefs, are not guarantees or projections of performance, should not be relied on, are subject to change due to a variety of factors, including fluctuating market conditions, and involve inherent risks and uncertainties, both general and specific, many of which cannot be predicted or quantified and are beyond our control. Future results could differ materially and no assurance is given that these statements are now or will prove to be accurate or complete in any way. Certain information herein was obtained from third party sources which we believe to be reliable, but Samson cannot guarantee the veracity of the information.