With Inflation Set to Rise, a Fresh Look at Active TIPS Strategies

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1 FEATURED SOLUTION February 2017 With Inflation Set to Rise, a Fresh Look at Active TIPS Strategies AUTHORS Mihir Worah CIO Asset Allocation and Real Return Jeremie Banet Executive Vice President Portfolio Manager, Real Return In recent years, many investors have become complacent about inflation risk on the back of falling commodity prices and slack in the economy. Now inflation fears have reemerged as commodity prices recover and the labor market tightens, while the Trump administration s proposed policies many of which are perceived to be inflationary fan the flames. We at PIMCO agree that inflation risk has risen and see potential for a transition to a higher inflation regime. With this in mind, it s important for investors to contemplate how best to prepare their portfolios. Real assets, including Treasury Inflation-Protected Securities (TIPS), can play an important role by aiming to mitigate the risks of higher inflation while also seeking to provide a portfolio with a key source of diversification relative to traditional stocks and bonds. Given their explicit link to inflation, TIPS are core to constructing inflation-fighting portfolios, in our view. The question becomes how investors can best harness the potential benefits of these securities.

2 2 February 2017 Featured Solution When considering an allocation to TIPS, the natural first step is to weigh the pros and cons of allocating to an active versus a passive manager. Both approaches offer potential benefits, costs and risks. That said, we believe actively managed TIPS portfolios can add value by seeking to capitalize on market inefficiencies in ways that passive managers can t. UNDERSTANDING INEFFICIENCIES IN THE TIPS MARKET The TIPS market is characterized by a number of inefficiencies that present potential hidden costs to passive indexers and concurrent opportunities to add value for skillful active TIPS managers. As a result, investors in passively managed TIPS products may pay more in total execution costs than the fees their passive managers charge imply. And this potential lost wealth may be transferred to more flexible active market participants (including hedge funds and market makers), who may then profit at the passive investor s expense. Below we summarize some of the inefficiencies that may allow this to happen: On-the-run/off-the-run relative value trading. A TIPS index includes all TIPS, both recently issued (on-the-run) securities and existing (off-the-run) securities. As a result, an index may hold two or more securities with very similar maturities: one that was just issued and an existing one with roughly the same time to maturity. A purely passive manager will replicate the index and hold both issues at index-specified weights. However, there may be a pricing advantage in holding a higher exposure to one of the securities and a lower exposure to the other while still maintaining the same overall duration and curve exposure as the index. These possible mispricing scenarios between on-the-run and off-the-run TIPS create opportunities for active managers to express relative value views while still maintaining the same key rate and overall duration as the TIPS index (see Figure 1). Figure 1: Pricing dislocations between on- and off-the-run TIPS create opportunities Cumulative return (%) 0% -1% -2% -3% -4% -5% New 10-year TIPS auctioned (Jan '25) Jan '25 TIPS (on-the-run) New 10-year TIPS auctioned (Jul '25) Jan '25 TIPS (off-the-run) -6% -7% Cumulative excess return (off-the-run vs. on-the-run, bps) Jan '15 Feb '15 Mar '15 Apr '15 May '15 Jun '15 Jul '15 Aug '15 Sep '15 Oct '15 Nov '15 Dec '15 Source: Barclays as of 31 December Past performance is not a guarantee or a reliable indicator of future results.

3 February 2017 Featured Solution 3 Index rebalancing. When new TIPS issues are added to the index post-auction, or when existing issues drop from the index as they near maturity, the composition and duration of the index change. Per index rules, these changes take effect at the end of the month and are predictable far in advance. Knowing that rule-following indexers will be buying or selling certain bonds at month-end, active managers may buy or sell TIPS in advance and reverse the trade to the indexers at month-end. Thus the passive investor may end up buying at elevated prices or selling at depressed prices while still exactly matching the index s performance. This presents another potential hidden cost that passive TIPS investors may repeatedly pay to more active participants in the market. Owing to this trading dynamic, TIPS have historically outperformed nominal Treasuries (richened) in the week preceding a month-end duration extension of the index (see Figure 2). For active investors, this recurring structural inefficiency presents an attractive risk-adjusted opportunity to add value relative to the passive index. Figure 2: Mechanical index rebalancing creates flow dynamics that can be exploited TIPS excess return relative to comparable nominal Treasuries (one week prior to month-end, %) TIPS index extension/contraction (years) Source: Barclays as of 30 November TIPS performance is measured relative to Treasuries, proxied by the Bloomberg Barclays U.S. TIPS Index relative to the Bloomberg Barclays U.S. Breakeven Inflation Linked Bonds Total Return Index (Index matches TIPS index with comparable nominal Treasury securities). Bloomberg Barclays U.S. TIPS Index is used to measure index rebalance duration changes. It is not possible to invest directly in an unmanaged index. Funding and liquidation costs. Though often overlooked, one component of the TIPS market structure that may be particularly costly to passive indexers is the market on close (MOC) trade order used by passive managers. TIPS indexes use market close prices to compute their index levels and daily returns, and MOC orders provide trade executions that nearly always match these prices. While this benefits passive managers or Wall Street dealers by reducing their risk of deviating from the client-specified index, it can be costly for the TIPS investor. Knowing that passive indexers require end-of-day pricing to track the TIPS index which means they will effectively act as price-indiscriminate buyers or sellers at or near market close active market participants will typically richen/cheapen the TIPS market into the close in order to profit at the indexers expense. This can be a significant cost to the passive investor upon both funding and liquidating TIPS positions. By contrast, active managers have a strong incentive to navigate around the adverse pricing dynamics that tend to occur near the market close; they instead look for the best intraday execution by continually assessing liquidity within the TIPS market. In this way, active managers may potentially provide more cost-efficient TIPS exposure to their clients, even after factoring in management fees. EXPANDING ACTIVE MANAGEMENT TO FURTHER ENHANCE POTENTIAL RETURN Taking advantage of the market s structural inefficiencies is not the only way active managers can seek to enhance returns after fees in TIPS allocations. Active managers of strategies focused on returns above inflation can also use various means to express top-down macroeconomic views and bottom-up views specific to the TIPS and other inflation-linked bond markets: Top-down strategies include: Duration positioning Positioning based on views of yield curve steepening/flattening Assessing TIPS relative value versus nominal Treasuries, based on shifts in inflation expectations Country rotation among inflation-linked bond issuers Limited sector rotation among high quality non-government sectors

4 4 February 2017 Featured Solution Bottom-up strategies include: Positioning to exploit seasonal consumer price inflation (CPI) patterns, which present a recurring opportunity to capture attractive risk-adjusted incremental return Inflation capture, or managing the mix of short and long TIPS to express an active view that CPI will print higher than the market expects Targeted issue selection Relative value trading based on the implied option value of receiving at least the original principal value upon maturity (i.e., the embedded deflation put) To further enhance potential returns, active managers who are willing to assume more risk can utilize alternative means to gain exposure, including the use of inflation swaps. Over recent history, the inflation swap market has become an efficient alternative to other transactions for gaining exposure to TIPS while also providing direct access to trading inflation. GOING ACTIVE With U.S. inflation fears likely to mount in the coming years, investors may contemplate increasing their TIPS allocations and a key decision will be how best to obtain that exposure. Allocating to a skilled active manager with a comprehensive set of TIPS strategies may enable investors to benefit from structural inefficiencies in the market and offer fertile ground for generating after-fee alpha.

5 Past performance is not a guarantee or a reliable indicator of future results. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Inflation-linked bonds (ILBs) issued by a government are fixed income securities whose principal value is periodically adjusted according to the rate of inflation; ILBs decline in value when real interest rates rise. Treasury Inflation-Protected Securities (TIPS) are ILBs issued by the U.S. government. Sovereign securities are generally backed by the issuing government, obligations of U.S. Government agencies and authorities are supported by varying degrees but are generally not backed by the full faith of the U.S. Government; portfolios that invest in such securities are not guaranteed and will fluctuate in value. Investing in foreign denominated and/or domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Derivatives may involve certain costs and risks such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested. 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