WIW - WIW's Underperformance Explained

2023-04-10 09:58:55 ET

Summary

• WIW invests in treasury inflation-protected securities, which see higher yields when inflation is high.
• WIW has posted sizable losses and underperformed during the current inflationary environment, higher yields notwithstanding.
• An explanation as to why follows.

Author's note: This article was released to CEF/ETF Income Laboratory members on March 26th.

I last covered the Western Asset/Claymore Inflation-Linked Opportunities & Income Fund ( WIW ), which focuses on treasury inflation-protected securities, or TIPs, in early 2022. In that article, I argued that WIW's inflation-protected investments should outperform when inflation rises, making the fund a buy. WIW has moderately underperformed most asset classes since, performing much worse than I expected.

Considering the above, I thought to write a quick article looking as to why the fund has performed so badly in the recent past. The explanation might be of interest to readers, and I definitely want to know what I got wrong.

WIW's losses were mostly due to higher interest rates, courtesy of the Federal Reserve. Rates were up, bonds were down, WIW invests in bonds so was down too.

WIW's underperformance was due to the fund's use of leverage, widening discount, and focus on particularly long-term bonds. Bonds were down across the board, but these three factors made WIW's losses particularly large.

WIW's inflation-protected securities did see higher yields as inflation rose, and these did benefit the fund, but the issues above mattered more.

In my opinion, the most important lesson from the above is the fact that the interest rate risk of most TIPs could significantly outweigh their hedge against inflation during a period of elevated inflation. Although this was always an issue, I discounted its importance and potential magnitude before 2022.

WIW - Quick Overview

WIW is an actively-managed CEF focusing on TIPs. Asset class weights are as follows.

WIW almost exclusively invests in investment-grade bonds with strong credit ratings. There is some small exposure to bonds rated A-BBB, and tiny exposure to non-investment grade bonds, but the overall portfolio is of very high quality.

WIW's interest rate risk is above-average, with a duration of 8.5 years.

WIW is a leveraged fund, with 37.4% of the fund's assets being bought with debt (reverse repurchase agreements specifically).

WIW's inflation-protected investments see rising interest rate payments and yields when inflation increases, which should result in higher distribution payments for the fund and its investors. This has been the case for the past two years or so, with WIW's monthly distributions doubling since early 2021, rising by 25% these past twelve months. Both are strong, above-average figures. WIW's total returns have, however, lagged behind strong distribution growth, with the fund down almost 24% since early 2022, underperforming both equities and bonds.

WIW's performance was worse than expected for an inflation-hedge fund. Let's have a look as to why.

WIW - Performance Analysis

Losses Analysis

WIW's losses were mostly caused by higher interest rates: rates went up, bond prices went down, as did bond fund share prices. Let's go through some of the details of this process, using the iShares 7-10 Year Treasury Bond ETF ( IEF ) as a simple example. I'll look at WIW soon enough, but IEF will prove instructive. All figures as of March 26, 2023.

IEF's largest holding is a 10Y treasury issued in late 2021 with a 1.38% coupon rate. Said rate is fixed until maturity, in late 2031.

A 1.4% yield looked reasonably compelling in late 2021, with interest rates at historical lows, and with t-bills yielding approximately zero. Investor demand for securities with these characteristics was reasonably good, and so prices were reasonable too.

A 1.4% yield is incredibly unattractive right now, with interest rates at elevated levels, and with t-bills yielding +4.0%. There is very little investor demand for securities yielding 1.4% right now, which means prices for these securities are quite low right now too.

So, as interest rates rose demand and prices for these older, relatively low-yielding treasuries decreased, leading to capital losses for their investors.

WIW's situation is broadly similar to the above, with a few complications and nuances.

WIW's largest holding is a 10Y TIPs which pays 0.625% plus inflation. Inflation averages around 2.0% per year, so said security pays around 2.6% per year on average. As with normal treasuries, there was strong demand and good prices for said security when rates were low. As rates have risen, demand has gone down, as have prices. WIW's share price has gone down in turn, as have TIPs prices (included a TIP index fund for reference / evidence).

The interesting thing is that the interest rate / yield on WIW's TIPs has increased quite a bit these past few years, due to rising inflation. CPI went from lower than 2.0% to 6.0% as of today, leading to a +4.0% increase in TIPs yield (exact figures vary depending on the time period analyzed). Said increase in yield had little impact on investor demand, or on security prices. Compare WIW's NAV with inflation, and you'll see almost no relationship at all, just a steady drift downwards.

Compare WIW's NAV with Fed rates, however, and you'll clearly see a negative relationship, with WIW moving a few months before the Fed, due to expectations.

Realized inflation had limited impact on TIPs prices for two reasons.

First, is the fact that investors expected, and continue to expect, inflation to moderate, and quickly. Surveys clearly show inflation expectations below realized inflation for years.

Breakeven rates, a market measure of inflation expectations, are quite low as well.

As investors expect inflation to moderate relatively soon, investor demand for inflation-hedged assets like TIPs is not particularly strong.

A second reason is the fact that the Federal Reserve hikes have been very aggressive this hike cycle. TIPs would have performed much better with a slower, more cautious Fed, and their inflation protection characteristics would have almost certainly played a more important role in this scenario.

As a final point, I do want to say that I expected a bit more investor demand for TIPs during an inflationary environment, which should have helped sustain their prices and returns. TIPs yield +7.0%, are protected against inflation, have effectively zero credit risk, have seen strong interest rate growth these past few months, and prices still collapsed. Results are understandable given interest rate movements, but I did expect them to be better.

Underperformance Analysis

WIW's losses were mostly caused by higher interest rates. The fund's underperformance was due to leverage, widening discount, and focus on particularly long-term bonds

The three issues above are, I think, pretty simple.

WIW uses leverage, which means more assets. More assets means higher capital gains when asset prices increase, and higher capital losses when these decrease. Prices decreased so WIW suffered increased capital losses, and hence underperformed.

WIW's discount widened from around 4.0% in early 2022 to 14.8% as of today.

Said widening lead to around 10% in losses to shareholders, on a price basis. NAV returns were stronger, but still quite weak.

Finally, WIW focused on bonds with somewhat longer maturities than average, which led to an above-average duration, and hence above-average losses when rates rose.

The three issues above did not cause WIW's losses per se, but they were instrumental in the fund underperforming relative to TIPs index funds.

Conclusion

WIW focuses on treasury inflation-protected securities. Although WIW sees higher income and distributions when inflation increases, the fund is down since inflation skyrocketed due to higher interest rates. WIW underperformed relative to its peers due to leverage, a widening discount, and a focus on long-term bonds.

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