U.S. inflation bonds back in vogue

NEW YORK Mon Sep 1, 2014 8:20am EDT

A home for sale sign hangs in front of a house in Oakton, on the day the National Association of Realtors issues its Pending Home Sales for February report, in Virginia March 27, 2014.  REUTERS/Larry Downing

A home for sale sign hangs in front of a house in Oakton, on the day the National Association of Realtors issues its Pending Home Sales for February report, in Virginia March 27, 2014.

Credit: Reuters/Larry Downing

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NEW YORK (Reuters) - U.S. investors are back in the hunt for inflation protection for the first time in two years as rising housing costs - particularly for rent - suggest inflation may finally be waking from its post-recession slumber.

That's helping to drive cash into specialty funds that focus on Treasury Inflation Protected Securities, or TIPS, arguably the weakest corner of the U.S. government bond market over the previous year or so, and helping TIPS significantly outperform regular Treasuries this year.

TIPS-focused funds are on pace to end seven consecutive quarters of outflows over which investors drained almost $38 billion from the sector. They've attracted $1.52 billion so far in the third period, marking the first quarterly inflows since the third quarter of 2012 and the largest since the first quarter of 2012.

Fund managers said the rising cost of housing - which accounts for as much as a third or more of various measures of inflation and is outpacing other consumer cost increases - has revived price pressure in the economy.

"TIPS have had a good tail wind this year. We have inflation as opposed to last year when we had disinflation," said Gemma Wright-Casparius, who oversees Vanguard's $26.3 billion inflation-protected securities fund, the biggest U.S. fund of its kind. The fund is up 6.5 percent this year.

Wright-Casparius also helps manage a short-dated TIPS fund whose assets have reached almost $10 billion since it launched nearly two years ago.

BETTING ON INFLATION

Inflation will likely creep higher in the coming months, according to a Reuters poll of economists. The Consumer Price Index has risen at 2 percent year-over-year for four straight months now and is forecast to accelerate to 2.2 percent later this year and into 2015, the data shows.

This outlook along with the possibility the Federal Reserve will raise interest rates in the middle of 2015 make TIPS a sensible choice, bond managers said. Also, the fact that Fed Chair Janet Yellen has signaled a willingness to let inflation run a bit hot relative to the central bank's target is also a positive, because the principal of a TIPS bond increases with inflation.

U.S. inflation bonds have produced a return of 6.35 percent since January, about 3 percentage points more than regular Treasuries, according to indexes compiled by Barclays.

In 2013, TIPS suffered their worst year since they were introduced in 1997, posting an annual loss of 8.61 percent compared with a decline of 2.63 percent for the broader Treasury market.

To be sure, it may be difficult for TIPS to sustain their recent gains.

"I think it's going to be much more challenging for them to generate returns as high as they have been in the past year or year to date," said Bill Irving, a Merrimack, New Hampshire, portfolio manager for Fidelity Investments, which manages $2 trillion.

That's because a sizeable portion of their gains this year are the result of an unexpected collapse in "real yields," or yields as measured against inflation. This proxy on the market's view on economic growth came after a stunning 2.9 percent drop in gross domestic product in the first three month of the year followed by a second-quarter 4.2 percent pop.

The real yield on 10-year TIPS, which move inversely with their price, tumbled from 80 basis points early in the year to 20 basis points recently. Shorter-dated real yields are actually negative, with inflation outstripping nominal yields.

A dramatic rally in bond markets worldwide, dragging U.S. yields back to their lowest levels in more than a year and yields on some European sovereign bonds to their lowest ever, further supported TIPS' revival. It is unclear, though, just how much more steam it has.

A variety of factors behind the rally include demand for low-risk sovereign bonds in face of conflicts in Ukraine and the Middle East and negative yields across the Atlantic where European Central Bank is expected soon to embark on new steps to avert Japanese-style deflation.

RISING RENTS

Ever since the housing market collapsed during the mortgage crisis seven years ago, more Americans have become renters, driving up demand for apartments and boosting rental costs.

A measure of that, known as owners'-equivalent rent, makes up 31 percent of the so-called core CPI. It was up 2.9 percent year-over-year in July, and a related measure of rent rose 3.2 percent, its fastest annual pace since March 2009. This trend could accelerate in the coming year, said Martin Hegarty, co-head of Blackrock's global inflation-linked $25.5 billion portfolio in New York, which has gained 6.22 percent this year.

"We are looking at shelter inflation in the next 12 to 18 months to touch the high 3 percent, maybe even 4 percent," Hegarty said. "That provides a relative stable base for everything else to build on top of."

A risk is that as rent and prices for food and other essentials rise higher, household spending more broadly could be pressured given the limited gains seen in the most widely tracked measures of wages.

But these fund managers say an underlying measure of wages, for private sector production and nonsupervisory employees, has been gaining ground at a faster clip, signaling consumers should be able to absorb higher costs.

Still, one signal from the TIPS market implies investors remain skeptical about wages and prices going much higher.

TIPS' breakeven rates, the differences between the yields on TIPS and nominal Treasuries and gauges of investors' inflation expectations, have fallen since the start of the year. The 10-year breakeven rate was 2.13 percent on Friday from 2.33 percent in early January.

Bond managers said the data will soon catch up their view and further declines in breakeven rates in the near term would offer investors cheaper levels to position for bigger profits in the long run.

"Ultimately, U.S. economic fundamentals will prevail and put upward pressure on rates but it could be some time before it takes hold," Fidelity's Irving said.

(Reporting by Richard Leong; Editing by Dan Burns and John Pickering)

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