The gap in yield between the 10-year TIP (Treasury inflation-protected security) and the regular 10-year Treasury surpassed two percentage points, as investors begin to price in expectations of inflation (see WSJ article). This comes on the day that Federal Reserve Chairman Bernanke warns of how longer-term deficits are threatening the financial stability of the U.S., as yields on longer-term Treasuries and fixed-rate mortgages rise (see Bloomberg article).

U.S. 10-Year Treasury
Source: BigCharts.com

iShares Barclays TIPS Bond Fund
Source: BigCharts.com

In an effort to take advantage of increased investor interest in Treasuries, Pimco (Pacific Investment Management Company) is launching its first ETF, the Pimco 1-3 Year U.S. Treasury Index Fund (ticker TUZ, see MarketWatch article). The current Pimco ETF was developed for investors with a focus on maintaining stable principle with little or no credit risk. The new ETF is one of approximately 65 fixed-income exchange traded funds listed in the U.S., a small number compared to the much larger equity ETF universe. In addition to the new ETF, Pimco filed prospectuses with the SEC for six additional ETFs. Three of the new ETF will cover the 3-7 year, 7-15 year, and 15+ year Treasuries. The remaining three will be tied to the U.S. TIPS, including a general TIPS Index Fund, a short maturity U.S. TIPS Index Fund, and a long maturity TIPS Index Fund. The Pimco TIPS funds are expected to compete with the iShares Barclays TIPS Bond Fund (ticker TIP, see chart above). Such products will give investors betting on hyperinflation, such as Nassim Taleb (see previous post), a new vehicle for placing their bets.

There is an interesting article from Bloomberg that discusses how TIPS (Treasury Inflation Protected Securities) are not living up to their goal of protecting against inflation. The principal for TIPS increase with increases in the CPI, yet many bond holders do not feel that the CPI is properly tracking inflation, in particular the large price increases in gasoline and soft commodities, such as corn. Even as prices have increased over the last 18 months, yields on TIPS relative to Treasuries have essentially stayed the same.

As an alternative, some investors are using swaptions, which when purchased give the buyer the right to purchase a swap. Swaptions are essentially options on interest-rate swaps. Inflation swaps allow one party to pay a fixed rate in exchange for the inflation rate. Lately, swaptions have been better at gaining value when the expectations of future inflation increase, even if the CPI is not keeping up. As an example, in April and May one-year inflation swaptions returned about 0.3%, compared with a 2% loss by TIPS of all maturities. Nonetheless, even while reacting to inflation better, some investors still prefer TIPS since they are backed by the government, unlike derivatives that depend on the credit quality of the issuing firm.