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How to invest in a inflation/deflation straddle?
Old 11-25-2008, 07:03 PM   #1
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How to invest in a inflation/deflation straddle?

Let's say you think the economy can only turn out one of two ways over the next 5 years (after that all bets are off):

1) Global economic slowdown. Not as bad as a depression but we do get substantial, sustained deflation and the general malaise that comes with it. The prices of commodities, stocks, real estate...everything declines.

2) Economy starts to come out of recession in 2009 as the impact of all the fiscal and monetary stimulus starts to have an impact. Unfortunately, it has too much of an impact, and we end up with substantial inflation. Not 100%/year, but perhaps 15-20%.

So given this outlook, is there any way to invest with a large payoff either way, but willing to accept losses if neither one of them comes true (its a mild recession then back to business as normal)? It seems like cash would be the best investment under #1, and TIPS or commodities under #2. Can anyone suggest a better straddle?

My premise is that with all the government intervention these days, either they are going to way undershoot or way overshoot the amount of the money to put into the economy.
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Old 11-25-2008, 07:26 PM   #2
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I appreciate the question, and can't think of much better. I would point out that the "payoff" of cash under #1 isn't so much a payoff, as just preservation of capital. And the same might be true to some extent of TIPS/commodities under #2. In fact, I'm scratching my head as to how to make money grow right now. I had a highly diversified portfolio going into this mess and it's all down.
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Old 11-26-2008, 12:53 AM   #3
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Cover your bets with a diversified portfolio.

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Old 11-26-2008, 01:12 AM   #4
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I'd also vote for diversification.

The "next 5 years" queston you've posed is interesting, and I'd sure like to have the answer. Still, do we need to make the call correctly only for the next 5 years, or is the long term more important. I'm thinking the long term call is both more important and easier: Does anyone think that American business and industries in the other industrialized countries won't be making money again? That developing countries won't eventually continue to develop? If we have confidence in these things, then the logical next step is to own portions of these businesses via a diversified basket of equities. Then wait (the hard part! )
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Old 11-26-2008, 08:49 AM   #5
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Two orthogonal situations, hard to invest in that, unless you rent some derivatives to hedge either bet.

The inflation one is hard to believe though. For real inflation to take off you have to see that stimulus push through to wages and income. This is very unlikely, income has been decreasing since 2000, and it's accelerating. And now there is so much labor and goods over capacity (in China, EU, USA), stimulus would at best keep our heads above water, and certainly not push us into inflation.

So I would bet for the slump case, with some hedging for the other. Hey - that's what I'm doing!
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Old 11-26-2008, 09:06 AM   #6
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Consider investing part of your portfolio in a strategy that benefits from volatility. (i.e. covered call fund)
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Old 11-26-2008, 11:50 AM   #7
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I am no economist so take the following comments with a big dose of salt.

It is a fact that real interest rates are higher than they have been in a long time. The Vanguard Tips fund is at about 3.5% real. This puts to shame my 2% + CPI inflation indexed bonds and their current value has dropped accordingly. However, I will just hold them to maturity over the next several years. In my opinion, this rise in real interest rates is predicting defaltion for at least a short time.

However, I just don't see the price of oil staying this low very long. Whenever the economy re-inflates, and it is bound to happen sooner or later with all stimulus being applied, oil and commodities are going to rebound sharply. This will drive up the price of everything just as it did during the last spike, even though wage inflation never broke through.

When this happens, year-over-year CPI will rise compared to the low base established during 2009. I think it likely that real rates will retreat and we will see nice capital gains on TIPS and inflation indexed bonds.

Thus one strategy would be to load up on TIPS and ride out the storm for the next year or two. At least the gov guarantees they will never go below par value at maturity.

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Old 11-26-2008, 11:58 AM   #8
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It is a fact that real interest rates are higher than they have been in a long time. The Vanguard Tips fund is at about 3.5% real.
Charlie, could you tell us how you discover that yield?

When I looked at Bloomberg.com, the only current yield apparently over 3 was 30 year, and it is selling a bit over par so I suppose amortization of the premium would have to be included to get a real ytm.

I find it hard to understand TIPS.

Ha
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Old 11-26-2008, 12:38 PM   #9
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When I looked at Bloomberg.com, the only current yield apparently over 3 was 30 year, and it is selling a bit over par so I suppose amortization of the premium would have to be included to get a real ytm.
I see the same thing that you do. Here is a nice table of all the outstanding TIPS:

TIPS Table

As you can see, most have real yields well over 3%. The rightmost column called "accrued principal" is the inflation component (in basis points) currently built into the maturity value. I believe the Treasury website calls this number the inflation factor, and it is multiplied times 100 to get the maturity payment in nominal $. Since most of these TIPS have been around for a while, they have a lot of past inflation built into the maturity value, and should we have deflation, this accrued principal can go down. When you buy TIPS in the secondary market you pay this accrued principal in addition to the price shown on Bloomberg (much the same way as you pay accrued interest when you buy any bond in the secondary market even though it's not quoted in the price of the bond). I think part of the reason we are seeing such high real yields in the TIPS market is because many investors fear losing some of this accrued principal should we have deflation, and they are demanding some extra compensation in terms of the real rate to offset this risk. It will be interesting to see the real rates at the January auctions of new securities with no accrued principal.
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Old 11-26-2008, 12:55 PM   #10
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I see the same thing that you do. Here is a nice table of all the outstanding TIPS:

TIPS Table

As you can see, most have real yields well over 3%. The rightmost column called "accrued principal" is the inflation component (in basis points) currently built into the maturity value. I believe the Treasury website calls this number the inflation factor, and it is multiplied times 100 to get the maturity payment in nominal $. Since most of these TIPS have been around for a while, they have a lot of past inflation built into the maturity value, and should we have deflation, this accrued principal can go down. When you buy TIPS in the secondary market you pay this accrued principal in addition to the price shown on Bloomberg (much the same way as you pay accrued interest when you buy any bond in the secondary market even though it's not quoted in the price of the bond). I think part of the reason we are seeing such high real yields in the TIPS market is because many investors fear losing some of this accrued principal should we have deflation, and they are demanding some extra compensation in terms of the real rate to offset this risk. It will be interesting to see the real rates at the January auctions of new securities with no accrued principal.
I see. Thanks. I will bookmark that table.

Ha
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Old 11-26-2008, 12:59 PM   #11
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It will be interesting to see the real rates at the January auctions of new securities with no accrued principal.
Could be. I suspect right now the market is preferring newer issues that haven't accrued much inflation-adjusted principal yet, since that puts a tighter floor on how far they can drop.

I own some of the Jan 2025 issue (2.375% coupon), and its "accrued principal" is 1160 (i.e. inflation adjustments have added 16%). That would seem to suggest that 13.8% of its current principal value can be eroded (160/1360 = 0.138) in a sufficiently deflationary atmosphere. A new bond, in contrast, can't lose any principal in a deflationary environment. But they also are priced to have a lower YTM as a result.
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Old 11-26-2008, 01:04 PM   #12
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A new bond, in contrast, can't lose any principal in a deflationary environment. But they also are priced to have a lower YTM as a result.
So by accepting some risk of deflation, you pick up YTM if this deflation does not happen.

I guess the key wold be to quantify this, so the risk/reward is clear. I think deflation over time is very unlikely, so if deflation risk is really being priced in, this could be a bargain.

People are accepting huge inflation risk today when they buy long T's. I would prefer to accept deflation risk, all else being equal.

Ha
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Old 11-26-2008, 01:12 PM   #13
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As usual I think that a diversified approach will be best to handle what is, no matter how much we think we know, an uncertain future. Right now it looks like we may be pricing in some deflation, but I don't see deflation last indefinitely. So, bond wise, I think that owning a mixture of intermediate to long term treasuries and TIPS would have served you well and will continue to do so.

With deflationary prospects on the horizon, intermediate term treasuries are up 8% this year (LT treasuries are up more than 11%) while TIPS are down 8%. So a 50/50 mixture of the two would have preserved your capital. If inflation comes back the trend should reverse with TIPS moving up again and treasuries coming down. I have added more TIPS to my portfolio lately. VIPSX has now a real SEC yield of 3.5% as per Vanguard.
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Old 11-26-2008, 01:19 PM   #14
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Ha, check the link below for current real rates:

U.S. Treasury - Daily Treasury Yield Curve

Also go to Vanguard's web site to check the current quote for
the Inflation-Linked Securities fund (VIPSX):

www.vanguard.com

Cheers,

charlie
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Old 11-26-2008, 02:05 PM   #15
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So by accepting some risk of deflation, you pick up YTM if this deflation does not happen.
Or if we do get deflation but not as much as is being priced into TIPS with significant inflation adjustments already accrued.
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Old 11-26-2008, 02:31 PM   #16
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Could be. I suspect right now the market is preferring newer issues that haven't accrued much inflation-adjusted principal yet, since that puts a tighter floor on how far they can drop.

I own some of the Jan 2025 issue (2.375% coupon), and its "accrued principal" is 1160 (i.e. inflation adjustments have added 16%). That would seem to suggest that 13.8% of its current principal value can be eroded (160/1360 = 0.138) in a sufficiently deflationary atmosphere. A new bond, in contrast, can't lose any principal in a deflationary environment. But they also are priced to have a lower YTM as a result.
Let's look at the inflation adjustments for the month of December for your TIPS. There is a 2 month lag in the inflation adjustment, so the Dec 1 number is based upon the Sep CPI-U, and the Jan 1 number is based upon the Oct CPI-U. The inflation adjustment is then interpolated linearly from these two CPI-U values each day for the month of December as shown in this table at the Treasury website:

Reference CPI and Index Ratios for Ziggy's TIPS

When you buy/sell this TIPS in the secondary market, your transaction price is multiplied by this ratio, so if you bought this TIPS on Dec 1 and sold it on Dec 31, you would lose about 1% due to this inflation adjustment, and the market knows this because the table is based upon already realized deflation in the month of October. This has to be getting factored into the real YTM.
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Old 11-26-2008, 05:04 PM   #17
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When you buy/sell this TIPS in the secondary market, your transaction price is multiplied by this ratio, so if you bought this TIPS on Dec 1 and sold it on Dec 31, you would lose about 1% due to this inflation adjustment, and the market knows this because the table is based upon already realized deflation in the month of October. This has to be getting factored into the real YTM.
Yes, I believe that about covers it. Because of this, the bond is priced at a discount relative to one that has not yet received any inflation adjustment (because the latter is still at par and can not drop in principal value). In other words, if we suddenly had deflation to take the "index ratio" on my TIPS back to 1.00, it would lose about another 13% of principal whereas the "new" TIPS would lose no principal. So in a deflationary environment, the market would discount those bonds with an inflation adjustment -- and the more the adjustment, the steeper the discount because of the possibility of more loss of principal.
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Old 11-26-2008, 05:56 PM   #18
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Yes, I believe that about covers it. Because of this, the bond is priced at a discount relative to one that has not yet received any inflation adjustment (because the latter is still at par and can not drop in principal value). In other words, if we suddenly had deflation to take the "index ratio" on my TIPS back to 1.00, it would lose about another 13% of principal whereas the "new" TIPS would lose no principal. So in a deflationary environment, the market would discount those bonds with an inflation adjustment -- and the more the adjustment, the steeper the discount because of the possibility of more loss of principal.
Exactly. But I think we can take this a step further. It's not just a possibility. The December table is now fixed for all existing TIPS. The Index Ratios may be different, but the CPI column is the same. This means that any existing TIPS purchased in the secondary market on Dec 1 will lose 1% of it's accrued principal during the month of December. This is a given, and it explains the higher real YTM's that we see in the shorter-term TIPS. Sort of like paying one point on a mortgage. If it's a 30-year mortgage it doesn't raise the APR as much as it would for a 15 year, and so on.
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Old 11-27-2008, 04:07 PM   #19
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One answer, probably not for everyone (or anyone?) that came from an old Harry Browne book: he added stocks and cash (t-bills), but imagine a portfolio of 50% gold coins or bullion (adjust type of holding to your level of wealth or paranoia -- buried in the back yard and/or in a swiss bank, etc.); and 50% in 30-year T-bonds. Or, if you really want a volatile deflation hedge, zero-coupons.
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