STIP - Consider STIP To Get Protection Against Recession

2023-04-24 13:49:33 ET

Summary

• The Treasury Inflation Protection Securities (TIPS) held by STIP are normally used to insulate a portfolio from the wrath of higher consumer prices.
• This thesis extends their usage to recession protection as well.
• The thinking behind this inflation is likely to remain higher for longer as the Fed has to perform a delicate balancing act between price and financial stability, after the banking turmoil.
• Getting exposure to STIP as part of a diversified investment including gold also makes sense, but there are also risks.
• This idea of using inflation-linked bonds, in this case government treasuries, is also supported by BlackRock, the world's largest asset manager.

The iShares 0-5 Year TIPS Bond ETF ( STIP ) is an exchange-traded fund managed by BlackRock (BLK) Fund Advisors. It is usually used to get protection from inflation as I will elaborate on later. Still, in this particular economic context, the aim of this thesis is to show that it is the right investment in case of a recession.

For this matter, as shown below, the negative values of the Chicago Fed Survey of Business Conditions indicate below-average growth of -35.44, implying a pessimistic outlook for the U.S. economy while at the same time, the core inflation rate remains persistently high at 5.59%.

Thus, with an unfavorable economic outlook on the one hand which is worsened by the banking turmoil, and high consumer prices on the other, it is important to choose wisely, but, first, I try to envision what this particular recession may look like.

Envisioning A Potential Recession

In this respect, one of the causes of the Great Financial Crisis of 2008 was toxic assets built out of opaque debt instruments exacerbated by inadequate supervision, but there was also a sharp rise in the prices of oil and agricultural products, but, unlike today, this was more due to a surge in demand.

Subsequently, with stocks and house prices falling, major U.S. and European banks lost a lot in terms of asset value. As a result, a battery of measures was adopted to reinforce the banking sector including more stringent capital requirements and stress tests. However, this did not prevent a bank run from occurring in small regional banks last month, but volatility also engulfed larger peers, and this shows that the banking turmoil did impact the whole industry in one way or another.

One reason was banks' assets being devalued due to their long-duration treasuries suffering from a drop in their value with yields going up as the Fed aggressively raised interest rates since 2022. With the inverse relationship between bond prices and their yields, valuations went down.

Staying within the realms of yields, as pictured below, the 10-2 treasury yield spread is the difference between the ten-year and the two-year treasury rates and currently stands at -0.6%. Now, this is illogical as the rate from the ten-year should be higher, as investors take more risk when lending their money (in this case by buying government bonds) for the long term than for two years. This "inversion" of the yield curve has acted as a consistent indicator of recession from 1995 to 2018, but, there is also the timing as the yield curve has been inverted since July 2022, and the fact that the economy has been growing in the meantime suggests that it is more of a far-leading indicator. However, the banking turmoil may accelerate things.

In this respect, as I explained in a previous thesis , the big banks have made more provisions for losses and liquidity conditions are getting tighter as lenders scrutinize the credit profiles of their customers in a more stringent manner. Now, since banks are the lifeblood for most businesses whether it is for capital or operations expenses, this raises the specter of an economic slowdown in the short term, as, on top, we are in a period where borrowing costs are still rising.

Recession-Protection Options And Diversification

Thus, with the odds of a recession being on the rise, it is essential to adjust your portfolio accordingly in case you have not already done so. Some would already have invested in gold or other precious metals, with the SPDR Gold Shares ( GLD ) having outperformed both the S&P 500 and STIP since the yield curve inverted as shown below in orange.

However, as shown in the deep blue chart below, STIP also managed to outperform the gold ETF momentarily, with that period coinciding with the start of the banking turmoil. The reasons could be that with rising inflation, the Federal Reserve would have to keep rates higher for longer, in turn giving support to the U.S. dollar, which in turn implies weakness for the price of gold and other commodities.

Thus, gold may not constitute the absolute defense mechanism against recession especially since higher interest rates may continue to provide support for the greenback. In these circumstances, it is better to opt for a diversified portfolio consisting of precious metals and inflation-protected treasuries.

Differentiating With Long-Dated Treasuries

Here, one of STIP's advantages is its overall value increases with inflation as the weighted average yield to maturity of the fund or its real yield is adjusted to remove the effects of inflation. As pictured below, it was 1.85% as of April 20, and this is the actual yield one will obtain. For this matter, the 12-month trailing yield of 5.04% does not account for rising consumer prices, for both goods and services or inflation.

For investors, inflation is the rate at which prices are rising across the entire U.S. economy, as measured by the CPI or Consumer Price Index, and becomes a problem when real wage growth does not offset the adverse effects of rising prices. As a solution, TIPS (Treasury Inflation Protection Securities) protects portfolios from inflation and enables shareholders to profit from it, as they pay interest every month based on a fixed rate determined when the bonds are auctioned.

By comparison, the iShares TIPS Bond ETF ( TIP ) as illustrated below and with a Weighted Avg Maturity of 7.33 years (compared to 2.49 years for STIP), pays a real yield of only 1.65%, or less. Therefore, STIP's short-dated treasuries pay better actual yields than the longer-duration ones held by TIP. Noteworthily, the contrary is the case for the 12-month trailing dividend yield paid each month, where TIP pays more, but which does not account for inflation.

Detailing STIP's dividend part, as pictured in the table below, the amount of monthly interest may vary since the rate is applied to the principal (or the adjusted value of the treasuries held). Hence, as the principal is adjusted over time, the interest rate will be multiplied each time by the new amount. As a result, investors receive higher interest as inflation rises. Conversely, expect to receive lower or even nil interest payments in the event of inflation coming down as was the case in February this year.

Making sense of it all, the monthly amounts correlate with the inflation movement as shown in the introductory chart, with the September 2022 payment of $1.25 for each share of STIP held coinciding with a surge in inflation, and shows the power of TIPS to deliver on their inflation protection mandate. They are also considered a low-risk investment because the U.S. government backs them.

Applying Moderation And Banking Woes Helps

However, just like other bonds, TIPS declines in value when real interest rates rise, as has been the case since March 2022 . Moreover, for those favoring yields, there are many other investment-grade bonds to choose from, especially given that prices are still down on a yearly basis. One such example is the Vanguard Short-Term Treasury ETF ( VGSH ) with an average effective maturity of 2 years.

Additionally, the problem with TIPS is that they provide a simple hedge against inflation whereby the values of the underlying bonds are adjusted, either up or down as inflation rises or falls. Thus, do not expect dividend payments for a sustained period in case of deflation or a fall in the price of goods and services.

Still, we are far from deflationary macros.

The reason is that the Fed, which favors another measure of inflation, the PCE index , wants to bring it back to around 2%, but its value was 5.0% in February on a year-on-year basis, which means a big difference. Now, the main inflation-controlling tool is to raise its rates, which also increases the cost of credit to discourage households and businesses to consume more. This should ultimately ease the pressure on prices, but at the cost of further tightening monetary policy because of the excessively high inflation differential of 3% (5%-2%).

However, the bankruptcy of Silicon Valley Bank and the ensuing banking turmoil could change the situation in the future. Thus, the U.S. central bank may opt for a modest rise in rates as the decision now not only depends purely on economic data but also on financial stability concerns. This, in turn, raises the prospects for inflation to remain higher for longer as I touched upon earlier, and increases the appeal of STIP, which unlike conventional treasuries makes adjustments in response to variable macros, while at the same time being backed by the Federal government.

A Thesis Backed By The World's Largest Asset Manager

In conclusion, this thesis has explained how STIP, which is normally used for inflation protection purposes, can also be extended to obtain relief in a recessionary environment. I also explained how it can be also used as a diversified anti-recession portfolio with gold. Also, the ETF charges fees of only 0.03%.

To this end, BlackRock, as part of a shift away from broader allocations to public equities and bonds, is holding an “ overweight ” position in inflation-linked bonds or ILBs , which, by the way, also include TIPS in addition to I-Bonds. The reason is that the world’s largest asset manager anticipates inflation to remain a persistent problem as a recession looms.

To be realistic, just as few predicted interest-rate-related risks impacting bank assets last month, it is unlikely for the events in a recession to unfold exactly as mentioned in this thesis. However, it remains a fact that periods of economic crisis tend to be deflationary as economic output typically slows down. This is also accompanied by lower investment and consumption. During such an occurrence, the Fed will surely have to apply the brakes on interest rates. Even then, STIP should still benefit, this time with its value going up just like for the bond asset class in general, as in 2020 after the Fed reduced rates to near zero levels.

Furthermore, as illustrated by the deep trough above occurring in March 2020, as part of the fixed-income asset class, TIPS should also prove volatile at the onset of a recession when panic usually grapples the markets. Finally, this is the reason that I do not have a buy rating.

Editor's Note : This article was submitted as part of Seeking Alpha’s Best Investment Idea For A Potential Recession competition, which runs through April 28. This competition is open to all users and contributors; click here to find out more and submit your article today!

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