US Rates: Value in 1Y and 5Y beta-weighted TIPS - HSBC

Weak CPI releases and a hawkish Fed have cheapened TIPS, with investors wondering whether this is a buying opportunity, according to the analysis team at HSBC.

Key Quotes

“The flattening of the nominal UST curve over the last six months has been a topic of discussion, with many investors being impressed by the magnitude of the move. However, the flattening across the US real yield curve has been even more pronounced, causing steepening of the break-even curve. The price action at the front-end is, in our view, fairly reasonable. US inflation peaked in February and the weakness in core CPI has caused a headache to long TIPS investors. Past experience has shown that a hawkish Fed is unsupportive for both front-end real yields and break-evens.  But a lot of this is already in the price.”

“Real yields at the front-end have risen at a faster pace than historical betas. This rise has been about 130bp since March, if we refer to front-end securities such as TII1.375 7/18. The 7/18 bond falls out of major TIPS indices in July and historically this has been a buying opportunity as 1Y securities are at their cheapest level at the time they exit the index. Moreover, July has historically been a positive return month for TIPS, with returns exceeding those of nominals in duration-adjusted terms. Similar to early 2016, if US inflation data keep softening then we expect the Fed’s rhetoric to become less hawkish and real yields should fall. Alternatively, investors who believe that the recent inflation prints were just a downside blip can lock into 1Y break-evens at around 145bp.”

“Return analysis and value

10-year TIPS yields (now 53bp) are slightly cheap to their 2017 33-61bp range; this measure has tended to mean revert. Break-even spreads are near the lower end of their 166-196bp range, as the reflation trade faded. Narrow ranges should continue in the near term as a quite summer is expected. 

Our projected return analysis of TIPS versus Treasuries signals that TIPS would underperform by roughly 50bp over the next 12-months if market inflation expectations and projected roll down the yield curve are realized. The 5-year area on a beta-weighted basis versus Treasury notes is the exception to this view, as its projected return matches comparable duration Treasuries and this weighted spread offers the best risk versus reward. Year-to-date, total returns for TIPS lagged Treasuries by -40bp to -450bp and -20bp to -400bp on a yield beta-weighted basis.”