Several months ago when I first staked out a neutral view of Treasury Inflation-Protected Securities (TIPS), I said that if break-even levels on 10-year TIPS approached 2%, I’d consider switching my view to overweight. With break-even levels now touching 2%, here’s why I’m maintaining my neutral view.
Just to review, the break-even level on a TIP security is the difference between the yield on an inflation adjusted bond and the yield on a plain vanilla bond. It represents investors’ implicit view on inflation over the life of the bond. Basically, it tells you how much bad news, i.e. inflation, the market is currently expecting.
As of last Thursday, break-even rates on TIPS were 2%, close to their 13-year average. In other words, investors expect inflation over the next decade to pretty much resemble inflation over the past decade. While there is some risk of inflation down the road, inflation is unlikely to be a problem for at least a couple years due to the anemic state of the economy. In other words, investors likely have time to hedge their inflation risk.
In addition, as the economy has decelerated over the past few months, one would expect the break-even level on TIPS to go down, indicating that investors are less worried about inflation. Macroeconomic factors, meanwhile, suggest that the TIPS break-even rate is just about where it should be given the slowing economy.
For now, I’m maintaining my neutral view of TIPS. At current prices, the bonds represent a reasonable inflation hedge if they are held to maturity. Still, they are not yet at a good enough value to justify an overweight view (potential iShares solutions: TIP, STIP, GTIP & ITIP).
Call #2: Maintain Overweight Healthcare & Telecom
This week, I’m also reiterating my preference for defensive equity sectors, particularly healthcare and telecom. Since the start of the month, both sectors have significantly outperformed the broader market. Global equities have lost around 10%, but healthcare is down only 5% and telecom is off around 7%.
While equities look inexpensive and appear to be a good long-term buy, markets are likely to remain volatile in the coming months. In this environment, defensive sectors — like healthcare and telecom — are likely to hold up better. These two sectors are also less dependent on economic growth than more cyclical sectors, such as retailers or mining stocks, and typically move up or down less than most stocks.
It is also worth highlighting that in addition to its defensive properties, telecom is currently yielding around 5%, more than double the yield on 10-year Treasuries. Telecom offers some income potential as well as a place to ride out a market rough patch.
Disclosure: Author is long IXP
Bonds and bond funds will decrease in value as interest rates rise. TIPS can provide investors a hedge against inflation, as the inflation adjustment feature helps preserve the purchasing power of the investment. Because of this inflation adjustment feature, inflation protected bonds typically have lower yields than conventional fixed rate bonds and will likely decline in price during periods of deflation, which could result in losses. Government backing applies only to government issued securities, not iShares exchange traded funds.
In addition to the normal risks associated with investing, international investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Narrowly focused investments typically exhibit higher volatility.