Some fixed-income managers are concerned they could lose a much-needed tool to hedge against medium-term price fluctuations if the Treasury Department stops issuing five-year Treasury inflation-protected securities (TIPS).
A proposal to that effect was presented by the Treasury Borrowing Advisory Committee (TBAC), comprising representatives from 14 money management firms and investment banks, at a July 29 meeting with Treasury officials in Washington. “I think discontinuing the five-year TIPS would remove liquidity from the market and hurt the entire TIPS program,” Mihir Worah, lead portfolio manager for the $15 billion (all figures are $US) Real Return Fund at PIMCO, said in an interview. “There is a need for liquidity across the yield curve to allow investors to better manage the specific inflation and real-rate risk,” added Worah.
Although PIMCO is a member of the TBAC, Worah said he was not privy to the closed-door discussions, beyond the minutes of the meeting published by Treasury. In the past, TBAC recommendations proved influential and were followed by important Treasury announcements, such as ending the 30-year Treasury bond in October 2001 or resuming the 52-week Treasury bill auctions in April.
One reason for ending five-year TIPS is the lack of liquidity in the $497 billion market, which has a low daily average turnover of just 2 per cent, or $8 billion, because of the buy-and-hold nature of the security. Because of its lack of liquidity, the TIPS market did not attract investors the way the $4 trillion US Treasury securities market did during the recent credit turmoil.
Further, the five-year issue is the shortest maturity on the TIPS curve — an investment horizon that some TBAC members saw as too limited. “The reason TBAC recommended the elimination of the five-year TIPS is because it believes Treasury can better capture the inflation risk premium at longer maturity points,” said Michael Pond, US fixed-income strategist at Barclays Capital in New York, after reviewing the minutes.
Barclays is the world’s largest TIPS dealer. Pond said regardless of the debate about the need for a five-year TIPS maturity, this is not the time to alter the Treasury program, given the turmoil in the credit markets. TBAC members also noted TIPS are a more expensive way than Treasuries to finance the government’s growing deficit, which will soar to a record $438 billion in 2009, according to the Congressional Budget Office.
The CBO estimate does not include the eventual cost of taking over the troubled mortgage lenders Fannie Mae and Freddie Mac. The committee, one of several formed by the Securities Industry and Financial Markets Association to work with the government on various market issues, estimated “that the aggregate cost of the TIPS program was over $30 billion,” since its inception in 1997.
The TBAC did not break down the figures for the five-year issue. “This cost reflects the fact that realised inflation has been higher than expectations,” the TBAC members also said. With TIPS, both the principal and the interest rate track changes in inflation as measured by the Consumer Price Index — a difference the Treasury must foot. For instance, for a five-year TIPS maturing this summer, Treasury would have to pay for the difference between the current CPI running at 5.6 per cent versus its subdued 2.1 per cent pace at the time of issuance five years earlier.
“The committee is saying the higher CPI is costing the government more money, but it’s faulty analysis. The use of five-year TIPS has actually saved the government a lot of money by reducing full coupon financing,” said Zane Brown, partner and fixed-income strategist at Lord Abbett & Co.