2023-09-13 08:20:58 ET
Summary
- The PIMCO 15+ Year U.S. TIPS Index Exchange-Traded Fund offers a great opportunity to profit from a potential decrease in US real (inflation-adjusted) borrowing costs.
- The LTPZ offer a 2% real yield in addition to payments tied to CPI, and will rise in price if long-term interest rate expectations fall relative to inflation expectations.
- The LTPZ has significant upside potential if real bond yields decline, which is likely due to the US government's rising debt servicing costs.
- A fall in long-term real bond yields to the lows seen in 2021 would see the LTPZ rise almost 70% before dividend income.
I have written a lot of late about the need for US real borrowing costs to come down sharply to prevent an exponential rise in US Treasury funding costs, and I think inflation-linked bonds are the best way to profit from this. The PIMCO 15+ Year U.S. TIPS Index Exchange-Traded Fund (LTPZ) represents one of the best opportunities I have ever seen from a risk-reward perspective. TIPS are Treasury Inflation Protected Securities (known as index-linked in the UK) that offer investors a hedge against inflation by paying income that is tied to consumer prices.
Like regular bonds that have a yield to maturity that reflects the annual return that investors will receive if they hold the bond to maturity, TIPS have a real (inflation-adjusted) yield to maturity, which is lower to reflect the fact that inflation is expected to be positive. The current real yield to maturity on the portfolio of bonds held by the LTPZ, which has an average maturity of 22 years, is around 2.1%, which compares with 4.5% on regular bonds of the same maturity, meaning that long-term inflation expectations sit at around 2.5%. This real yield is abnormally high compared to its long-term average going back to the late 1990s.
20-Year TIPS Yield (%), 20-Year Treasury Yield (%), and Difference (Inflation Expectations) in basis point (Bloomberg)
The main reason to hold the LTPZ, however, as compared with shorter duration inflation-linked bond funds, is that it has tremendous potential upside if real bond yields decline, which I think is all but inevitable due to the US's government's rising debt servicing costs. As a long-duration bond fund, the LTPZ is highly sensitive to changes in real bond yields, that is, the change in long-term interest rate expectations relative to long-term inflation expectations. As the chart below shows, if 20-year real bond yields were to fall back to their 2021 lows of around -0.7%, the LTPZ should rise by almost 70% even before dividend income.
LTPZ Vs 20-Year TIPS Yield (Bloomberg)
Fed Intervention Will Be Required To Drive Bond Yields Down And Inflation Up
On the current trajectory, the US Treasury is heading straight towards a funding crisis due to its huge fiscal deficit and rising interest payments on its debt, which sits at 120% of GDP. Even though its average cost of borrowing remains relatively low at 3% reflecting the long maturity of its debt load, interest payments are already equivalent to 3.6% of GDP and 20% of Federal current tax revenues. Once the impact of recent interest rate hikes feed through and interest costs rise in line with the current 10-year yield of 4.3%, this will raise interest payments above 5% of GDP and almost 30% of tax revenues, in line with the level seen in the 1980s when bond yields were a staggering 16%.
Orange: US Debt Effective Interest Rate. Yellow: 10-Year UST Yield. White: Interest Payments, % of Current Federal Receipts (US Treasury, Bloomberg)
In the 1980s, the government was forced to run primary fiscal surpluses in order to bring borrowing costs under control, which were achieved by President Reagan's free-market policy reforms and cuts in real spending. A repeat of such measures seems highly unlikely. The current primary fiscal deficit is 5% of GDP even with the economy at full employment, and there is little appetite among the American public for meaningful spending. Poling data shows that while most Americans like the idea of a balanced budget, they are also heavily in favor of raising spending on every single major government program.
Washingtonpost.com
Even if the US avoids recession, and we ignore the impact of the ageing population on entitlement spending, with a primary deficit of 5% of GDP and interest costs of 5% of GDP, the US government debt load should rise by 10% per year. With trend growth likely to average less than 1% as I argued here , and long-term inflation expected to average 2.5%, nominal GDP growth should average around 3.5%, which would mean the US debt to GDP ratio should rise by 6.5% annually. If we extrapolate this out just 5 years, the debt to GDP ratio would rise to 165% and at 5.5% interest rates the Treasury's annual interest bill would rise to 9% of GDP and one half of Federal current tax revenues.
Forecasts Based On Cost Of Capital Rising To Current Fed Funds Rate, Nominal GDP Growth of 3.5% And Primary Fiscal Deficit Of 5% (Bloomberg, Author's calculations)
It should be easy to see how this is a completely unsustainable path. To prevent the debt to GDP ratio rising, the Treasury would have to turn the 5% primary deficit into a surplus. Failing this, in anticipation of further debt issuance, investors are likely to require higher yields on government debt. To prevent such a rise from further driving up borrowing costs and further widening the fiscal deficit in a self-reinforcing manner, the Federal Reserve will have to step in to cap bond yields.
Board of Governors of the Federal Reserve System (1976).
In order to do this, it must create base money out of thin air and by doing so it is likely to fuel a rise in inflation. This tactic was used during the 1940s to allow the government to fund the War effort, with the 10-year bond yield capped at 2.5% from 1942 to 1951. To keep yields pinned below market rates, the Fed ended up owning almost all the available stock of public debt by 1947, which it bought with newly created base money. Unsurprisingly, inflation rose to as high as 20% meaning that real 10-year yields registered -18%.
Risks Are Limited To Positive Scenarios
From a short-term perspective, the main risk to the LTPZ comes from another leg higher in global stocks, which would likely force the Fed to keep interest rates higher than expected for longer than expected. However, another thing I like about the LTPZ is that if it performs poorly over an extended period, it is likely to be the result of an improvement in the US fiscal position and real GDP growth outlook. Real bond yields are closely linked with real GDP growth and if the US economy can sustain positive real yields, it would suggest the government has found a way to reduce government spending, which is positive for real returns on almost all assets. Put another way, the LTPZ should trade at a premium as it offers investors protection against runaway fiscal spending and weak real GDP growth.
For further details see:
LTPZ: TIPS Have The Best Risk-Reward Outlook I Have Ever Seen