One issue with TIPS is their performance in 2008:
Some investors say TIPS didnt protect you in 2008, so Im not using TIPS because thats when bonds should work.
The Lehman Brothers bankruptcy is at the heart of why the TIPS market acted so strangely. In 2009 the United States Government Accountability Officewrote:
Lehman Brothers owned TIPS as part of repo trades or posted TIPS as counterparty collateral. Because of Lehmans bankruptcy, the court and its counterparty needed to sell these TIPS, which created a flood of TIPS on the market.
Lehmans counterparties and the bankruptcy court were forced sellers. A relative value fixed income fund named The Barnegat Fund was on the other side of the trade.
Barnegat noted the triple whammy facing TIPS in 2008:
Real return funds took a bath on commodities and were also forced to sell TIPS
Nobody was interested in allocating to relative value funds like Barnegat letting the arbitrage persist for longer
Barnegat bought TIPS, shorted Treasuries, and hedged out the inflation risk with inflation swaps.Without the swaps the trade would be a direct bet on inflation.
There wouldnt be a huge arbitrage opportunity if TIPS were accurately reflecting inflation expectations. But the inflation swaps market wasnt affected by the forced TIPS selling and priced in a less deflationary future than TIPS.
At its peak, the trade netted 2.5% on unleveraged capital with zero credit risk, zero rate risk, and zero inflation risk. Barnegat returned+132% in 2009and researchers nicknamed the trade the largest arbitrage ever documented in the literature.
Geek Note: A number of funds had this trade on but some were unable to hold it through the crisis.A letter from Barnegatexplains two of the unique ISDA clauses that helped them hold the trade to maturity.
Heres a video of Barnegats founder talking about the trade:
While TIPS have been more positively correlated to stocks than regular Treasuries, their performance in 2008 was more of a one-off event than a blueprint for how theyll perform in the next downturn.
For example, TIPS and Treasuries closely tracked each other during the early 2000s recession:
This is the third post in a five-part series on TIPS. Links to the previous two:
On Monday Ill explain why TIPS are not the tax nightmare theyre made out to be and show an attractive TIPS alternative thats available until October 31.
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