Gross caught in TIPS trap Gundlach sidestepped as bonds fell

Buying TIPS

After TIPS tumbled following lower-than-average demand at the Treasury’s five-year auction in April, Gross wrote in an April 19 Twitter message that he was buying more inflation- protected debt. And in a June 6 interview on Bloomberg Television’s “Market Makers,” Gross said he continued to expect that “trillions of dollars of check writing” by central banks would spur enough inflation during the next three to five years to give some “traction” for insurance against rising prices “on the TIPS side.”

Jeremie Banet, a Pimco portfolio manager who specializes in inflation-linked investments, said in an interview that the contraction of the break-even rate shows that the market doesn’t see the economic improvement that the Fed is citing as a basis for tapering. If the market did see that the economy was expanding, inflation expectations would rise, leading to a higher break-even rate, Banet said.

‘Premature Tightening’

“We think the reason interest rates are rising is because people expect the Fed to be less accommodative,” not because the economy is improving, Banet said in a telephone interview. “If inflation is really as low as what is priced into the TIPS market,” Banet said, the Fed “should be concerned about premature tightening.”

The change to the Fed’s asset purchases that Bernanke signaled by itself was too small to drive the decline in financial markets that followed, said Wynn at Western Asset. His closed-end fund has declined 7.5% this year through July 2, trailing 81% of peers.

The market declines began with money-losing bets that leveraged hedge funds made on the outcome of Japanese government stimulus efforts and have snowballed because banks, faced with higher capital requirements, are providing less liquidity when volatility increases, according to Wynn.

“Fundamental to the price action in the last month-and-a- half is the leveraged investors unwinding,” Wynn said in a telephone interview. “The TIPS market has been a casualty of this environment.”

Risk Parity

Within the TIPS market, much of the recent selling came from risk-parity funds that follow an asset-allocation strategy pioneered by Dalio, the founder of Bridgewater Associates LP in Westport, Connecticut, according to Wynn and four other managers and dealers who trade inflation-linked debt.

These funds, which seek to diversify by the types of risk they face under different economic environments, typically devote 25 to 60% of the notional value of their assets to inflation-linked bonds, including TIPS, said Tim McCusker, the head of traditional research at NEPC LLC, a Cambridge, Massachusetts, investment consultant to pension plans, foundations and endowments.

While risk-parity strategies are designed to provide higher returns in a variety of economic environments, they fare poorly when there is a tightening of monetary policy or an expected tightening, McCusker said. The $1.2 billion AQR Risk Parity Fund, run by Cliff Asness’ AQR Capital Management LLC, has fallen 11% since the end of April, according to data compiled by Bloomberg.

Balancing Portfolios

Michael Mendelson, a portfolio manager for AQR’s risk- parity strategies, said in a telephone interview that some risk- parity managers sold TIPS last month to bring their portfolios back into balance or to reduce their holdings. He also said that the aggregate holdings of such traders in all types of global inflation-linked bonds, not just TIPS, was only in the “mid- tens of billions” and therefore too small to drive the market’s recent decline.

“Risk-parity investors are important TIPS investors, but we are not that important,” Mendelson said.

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