Let me ask you a personal question…
Do you use protection?
Because based on the recent, wild action in the markets, it seems as though many people have been practicing unsafe investing.
Across the market, people are finding themselves overexposed to richly valued equities and underexposed to volatility-dampening U.S. Treasuries. They ignored the myriad warnings the market was sending throughout the year and were poorly positioned.
This week, they overcompensated by frenetically selling stocks and buying government bonds, providing what’s known as a “flight to safety” bid for Treasuries.
But to be successful, we have to buy safety before the flight to safety. In other words, safe investors buy protection before they need it.
There’s nothing worse than getting caught with your pants down, but you shouldn’t be chasing the iShares Barclays 20+ Year Treasury Bond ETF (TLT) or iShares Barclays 7-10 Year Treasury Bond ETF (IEF) as they move higher, either.
That’s because the risk-reward dynamics have changed significantly for Treasuries since the beginning of the year.
U.S. 10-year rates hit 1.9% on Wednesday morning amid out-of-this-world Treasury futures trade activity.
Perhaps poorly managed hedge funds have finally capitulated on their bond shorts (bet on rising interest rates). Remember, the 10-year was near 3% at the start of the year.
Interestingly, the collapse in the price of oil and global growth worries are stoking fears of continued disinflation (declining rate of inflation), which actually makes government bonds more attractive.
Indeed, inflation expectations have reached three-year lows.
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The predictions for higher interest rates that were so prevalent early in 2014 are starting to give way to predictions of outright deflation.
To be sure, the demographic changes and debt overhangs that are helping to push global government bond yields down will persist for quite some time.
However, as astute investors, we should utilize the short-term oscillations and sentiment changes to seek the best opportunities. We should now be looking for securities that are currently on sale, and those that are sensitive to inflation expectations fit the bill.
Just the TIPS
Treasury inflation-protected securities (TIPS) pay a fixed rate on a principal value that adjusts for inflation as measured by the Consumer Price Index (CPI). Unlike traditional fixed-income securities, TIPS provide your capital with protection against the ravages of inflation.
The most popular TIPS exchange-traded fund is the iShares TIPS Bond Fund ETF (TIP). To give you an idea of how unpopular TIPS are right now, total fund assets for TIP have declined from over $23 billion in 2012 to under $13 billion currently.
As intriguing as that is, though, the real opportunity lies in a relatively unknown fund…
The Western Asset Claymore Inflation-Linked Securities Income Fund (WIA) is a closed-end fund that invests at least 60% of its total assets in U.S. TIPS. WIA trades at a whopping 15% discount to net asset value (NAV), and has a 3.3% trailing 12-month yield.
So, not only are you opportunistically buying an out-of-favor asset class category, but you have additional protection from effectively buying the securities for $0.85 on the dollar.
As the fear of deflation proliferates, TIPS becomes more and more attractive relative to traditional Treasuries. The closed-end fund WIA is a fantastic way to invest in this unloved and under-owned portion of the Treasury market.
Safe (and high-yield) investing,
Alan Gula, CFA