Inflation Hedge by buying options on TIP

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Inflation Hedge by buying options on TIP

Post by skierincolorado »

I see a lot of posts on this forum about how to best hedge inflation. TIPS are the best inflation hedge I've seen discussed, but require large amounts of capital to be allocated. One can buy deep ITM options on TIP with implied interest at about 1.6% including foregone distributions. The delta was still at around .90 on that though so there is some downside protection as well. While this interest is higher than a box spread, it's lower than most broker margins. 1.6% is also higher than the expected return on TIP return now, which is probably a little less than the yield on the 10 year, since the duration is just under 8 years and TIPS have slightly lower long-term returns than regular Treasuries. So you'd expect to lose money by doing this in the long-run (guessing -.5%/yr). But it could help reduce risk and smooth out periods of inflation. And if you include the downside protection which could come in handy in the long-run, maybe it's more like breakeven than -.5%.
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Re: Inflation Hedge by buying options on TIP

Post by bikenfool »

Why do you say TIPS "require large amounts of capital to be allocated" ??
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Re: Inflation Hedge by buying options on TIP

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Just buy more stocks
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Re: Inflation Hedge by buying options on TIP

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bikenfool wrote: Mon May 03, 2021 10:46 pm Why do you say TIPS "require large amounts of capital to be allocated" ??
Perhaps he means because they only protect themselves?
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Re: Inflation Hedge by buying options on TIP

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skierincolorado wrote: Mon May 03, 2021 7:19 pm I see a lot of posts on this forum about how to best hedge inflation. TIPS are the best inflation hedge I've seen discussed, but require large amounts of capital to be allocated. One can buy deep ITM options on TIP with implied interest at about 1.6% including foregone distributions. The delta was still at around .90 on that though so there is some downside protection as well. While this interest is higher than a box spread, it's lower than most broker margins. 1.6% is also higher than the expected return on TIP return now, which is probably a little less than the yield on the 10 year, since the duration is just under 8 years and TIPS have slightly lower long-term returns than regular Treasuries.
Que?

10 YR has negative real yield right now.

And with TIPS you have to pay the extra principal upfront.
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Re: Inflation Hedge by buying options on TIP

Post by skierincolorado »

watchnerd wrote: Mon May 03, 2021 11:09 pm
skierincolorado wrote: Mon May 03, 2021 7:19 pm I see a lot of posts on this forum about how to best hedge inflation. TIPS are the best inflation hedge I've seen discussed, but require large amounts of capital to be allocated. One can buy deep ITM options on TIP with implied interest at about 1.6% including foregone distributions. The delta was still at around .90 on that though so there is some downside protection as well. While this interest is higher than a box spread, it's lower than most broker margins. 1.6% is also higher than the expected return on TIP return now, which is probably a little less than the yield on the 10 year, since the duration is just under 8 years and TIPS have slightly lower long-term returns than regular Treasuries.
Que?

10 YR has negative real yield right now.

And with TIPS you have to pay the extra principal upfront.
When you invest in treasuries you get the nominal yield not the real yield. Leveraging a positive yield is more positive. The expected return on TIPS is also positive after the CPI adjustment (hence 'return' not 'yield'), but probably a hair lower than on regular treasuries because there is less risk. If you could leverage this return with financing costs lower than the expected return, you'd make money (on average). But the financing costs on TIP options are bit high in my example, so the return is probably near zero. But it would be a powerful inflation hedge if that's what someone is after.

It was hard to calculate the financing cost exactly since the options were not so deep in the money for the delta to be near 1 (more like .85 or .9). Not really recommending this unless someone is highly leveraged and wants an inflation hedge. Otherwise better to just buy TIPS. It's unclear to me if this would beat buying TIPS on a box spread.
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Re: Inflation Hedge by buying options on TIP

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skierincolorado wrote: Mon May 03, 2021 11:35 pm

When you invest in treasuries you get the nominal yield not the real yield.
No, 10 YRs from now, you're going to be dealing with negative real yields, no matter which one you buy.

Why are you borrowing money to buy something that will be worth less in the future?

Unexpected inflation would have to be extraordinarily crazy high for this gambit to pay off.

To make money 10 YRs from now you need to have an IRR that exceeds inflation plus cost of finance.
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Re: Inflation Hedge by buying options on TIP

Post by skierincolorado »

bikenfool wrote: Mon May 03, 2021 10:46 pm Why do you say TIPS "require large amounts of capital to be allocated" ??
TIPS are pretty unique in that they are the only instrument that directly hedges changes in inflation expectations.

The inflation hedge would be highly desirable to somebody concerned about inflation. But they also might not want to put a large portion of their portfolio into an otherwise low-return low-risk asset like bonds in order to get this inflation hedge. Options on a TIPS ETF like TIP gets the inflation hedge (and interest rate exposure) while still allowing to allocate a large portion to other investments (equities most likely).
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Re: Inflation Hedge by buying options on TIP

Post by skierincolorado »

watchnerd wrote: Mon May 03, 2021 11:38 pm
skierincolorado wrote: Mon May 03, 2021 11:35 pm

When you invest in treasuries you get the nominal yield not the real yield.
No, 10 YRs from now, you're going to be dealing with negative real yields, no matter which one you buy.

Why are you borrowing money to buy something that will be worth less in the future?

Unexpected inflation would have to be extraordinarily crazy high for this gambit to pay off.

To make money 10 YRs from now you need to have an IRR that exceeds inflation plus cost of finance.
You are comparing the real yield of an investment to the nominal cost of borrowing. That's apples to oranges.

One is also borrowing at negative real rates. Let's just stick to nominal returns and nominal borrowing costs. The nominal expected return of TIP is probably around 1.5% (negative yield, plus 2.5% inflation expectation currently) right now. The borrowing cost of these options would be similar or more likely a bit less than that.

From my rough calculations the borrowing cost is roughly equal to the expected return. So net zero. But it would make large moves in the opposite direction of inflation expectations and most other assets (stocks, bonds), which could be beneficial in a risk-parity type approach. I'm guessing leveraging using box spreads would reduce the finance cost further and work a little better.
Last edited by skierincolorado on Mon May 03, 2021 11:49 pm, edited 1 time in total.
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Re: Inflation Hedge by buying options on TIP

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skierincolorado wrote: Mon May 03, 2021 11:42 pm

You are comparing the real yield of an investment to the nominal cost of borrowing. That's apples to oranges.

One is also borrowing at negative real rates.
Walk me through your math, because I'm not getting it.

10 YR Breakeven Inflation = 2.41%
10 YR Treasury Yield = 1.65%
Real Yield = -0.76% = TIPS yield

So you're already in the hole, 10 Years from now....

And now you want to borrow money at 1.6% as an additional cost on top of that?
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Re: Inflation Hedge by buying options on TIP

Post by skierincolorado »

watchnerd wrote: Mon May 03, 2021 11:47 pm
skierincolorado wrote: Mon May 03, 2021 11:42 pm

You are comparing the real yield of an investment to the nominal cost of borrowing. That's apples to oranges.

One is also borrowing at negative real rates.
Walk me through your math, because I'm not getting it.

10 YR Breakeven Inflation = 2.41%
10 YR Treasury Yield = 1.65%
Real Yield = -0.76% = TIPS yield

So you're already in the hole, 10 Years from now....

And now you want to borrow money at 1.6% as an additional cost on top of that?
TIPS yield -.76% right now, but the CPI adjustment is applied monthly to the bonds, which is expected to be 2.41% over the life of the bonds, as you said. So the expected return on TIPS right now is ~1.6% currently. If inflation is more than 2.4% over the next 10 years, they will return more. If inflation is less than 2.4% over the next 10 years, they will return less. So there is risk if inflation is more or less than expected, but if inflation matches market expectations, the expected nominal return is 1.6% on TIPS. The nominal borrowing cost for these options is a bit less than that. And the borrowing cost on a box spread is more like .5%, so positive expected value and powerful inflation hedge.
Last edited by skierincolorado on Mon May 03, 2021 11:55 pm, edited 1 time in total.
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Re: Inflation Hedge by buying options on TIP

Post by Astones »

I checked.

For a call option expiring in June 17 2022, strike price 125, you pay about 3.50 in premium

This means 3.50/125 = 0.028
So 2.8 %. This value must be removed from whatever return you'll get from interests/capital gains of the ETF during one year.

Unless I made some mistakes, it doesn't sound such a good deal to me.
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Re: Inflation Hedge by buying options on TIP

Post by skierincolorado »

Astones wrote: Mon May 03, 2021 11:55 pm I checked.

For a call option expiring in June 17 2022, strike price 125, you pay about 3.50 in premium

This means 3.50/125 = 0.028
So 2.8 %. This value must be removed from whatever return you'll get from interests/capital gains of the ETF during one year.

Unless I made some mistakes, it doesn't sound such a good deal to me.
You don't subtract the 3.50 in your example, that's not how options work. You pay 3.50 now. If the ETF price doesn't change at all (126.70) you would make 1.70 back and lose 1.80. It's the 1.80 that needs to be subtracted. You also need to subtract any distributions the fund made because owning an option you don't get those distributions. Those distributions have averaged 1.1%/year recently. That's another $1.35 or so. So you need to subtract $3.15 not $3.50.

On the other hand, you are paying extra because your downside is protected. If TIP falls below 125 you stop losing money, which has a real probability around 20% that you are paying extra to protect against.

You need to find an option that is deeper in the money, like a 120 strike price.

For a 120 strike 1 year from now it costs about 7.30. The option is very likely to be exercised and if the price doesn't change at all you lose $0.60. You also forego $1.35 in distributions. So you missed out on $1.95 compared to actually owning the ETF. 1.95/126.70 = ~1.6% financing. This still includes some downside protection because TIP could still fall below 120. To really calculate the financing cost you'd need a strike of $115, but those have huge bid-asks.
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Re: Inflation Hedge by buying options on TIP

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Astones wrote: Mon May 03, 2021 11:55 pm I checked.

For a call option expiring in June 17 2022, strike price 125, you pay about 3.50 in premium

This means 3.50/125 = 0.028
So 2.8 %. This value must be removed from whatever return you'll get from interests/capital gains of the ETF during one year.

Unless I made some mistakes, it doesn't sound such a good deal to me.
That might be tough in a rising rate environment.

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Re: Inflation Hedge by buying options on TIP

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skierincolorado wrote: Tue May 04, 2021 12:05 am

You need to find an option that is deeper in the money, like a 120 strike price.

For a 120 strike 1 year from now it costs about 7.30. The option is very likely to be exercised and if the price doesn't change at all you lose $0.60. You also forego $1.35 in distributions. So you missed out on $1.95 compared to actually owning the ETF. 1.95/126.70 = ~1.6% financing. This still includes some downside protection because TIP could still fall below 120. To really calculate the financing cost you'd need a strike of $115, but those have huge bid-asks.
I'd feel a lot more confident that you have this all sorted out if you weren't using terms such as "like" and "about", but instead were quoting specific prices for exact dates.

If this were some kind of free lunch to protect an entire portfolio from inflation, it would be standard practice.
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Re: Inflation Hedge by buying options on TIP

Post by skierincolorado »

watchnerd wrote: Tue May 04, 2021 12:08 am
skierincolorado wrote: Tue May 04, 2021 12:05 am

You need to find an option that is deeper in the money, like a 120 strike price.

For a 120 strike 1 year from now it costs about 7.30. The option is very likely to be exercised and if the price doesn't change at all you lose $0.60. You also forego $1.35 in distributions. So you missed out on $1.95 compared to actually owning the ETF. 1.95/126.70 = ~1.6% financing. This still includes some downside protection because TIP could still fall below 120. To really calculate the financing cost you'd need a strike of $115, but those have huge bid-asks.
I'd feel a lot more confident that you have this all sorted out if you weren't using terms such as "like" and "about", but instead were quoting specific prices for exact dates.

If this were some kind of free lunch to protect an entire portfolio from inflation, it would be standard practice.
Oh it's not free at all. You'd be allocating capital to something with an expected return of near zero. In return, your portfolio would experience less volatility. And the long-term return would be reduced by the return you could have achieved investing the same capital in stocks.

I'm using terms like like and about because the numbers change.

It was $7.30 for a Jun '22 $120 strike today. TIP was at 126.70 at the time. You'd lose out on $0.60 (120+7.30-126.70) and the expected distributions (varies but likely ~$1.35) in that timeframe. For this cost of 0.60+1.35 = 1.95, you'd get the returns of 126.70 worth of TIP. That's a 1.53% cost. The share of TIP you control also has an expected return of ~1.5% currently, so it's a net wash. The expected return is zero, but you gain a powerful inflation hedge and anti-correlated asset exposure.
Last edited by skierincolorado on Tue May 04, 2021 12:24 am, edited 1 time in total.
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Re: Inflation Hedge by buying options on TIP

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skierincolorado wrote: Tue May 04, 2021 12:19 am

Oh it's not free at all. You'd be allocating capital to something with an expected return of near zero. In return, your portfolio would experience less volatility. And the long-term return would be reduced by the return you could have achieved investing the same capital in stocks.
If you're just trying to reduce volatility, why not use leverage to implement a risk parity strategy?
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Re: Inflation Hedge by buying options on TIP

Post by skierincolorado »

watchnerd wrote: Tue May 04, 2021 12:23 am
skierincolorado wrote: Tue May 04, 2021 12:19 am

Oh it's not free at all. You'd be allocating capital to something with an expected return of near zero. In return, your portfolio would experience less volatility. And the long-term return would be reduced by the return you could have achieved investing the same capital in stocks.
If you're just trying to reduce volatility, why not use leverage to implement a risk parity strategy?
That's what deep in the money options are, leverage. Usually it's cheaper leverage than what the broker offers. Box spread will be cheaper, but this is simpler.

Control $126.70 of TIP with $7.30 in capital at a <1.6% financing cost. I say 'less than' because part of the 1.6% you are paying is downside protection (you stop losing if TIP goes below the strike of 120).
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Re: Inflation Hedge by buying options on TIP

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skierincolorado wrote: Tue May 04, 2021 12:26 am

That's what deep in the money options are, leverage. Usually it's cheaper leverage than what the broker offers. Box spread will be cheaper, but this is simpler.

Control $126.70 of TIP with $7.30 in capital at a <1.6% financing cost. I say 'less than' because part of the 1.6% you are paying is downside protection (you stop losing if TIP goes below the strike of 120).
Yes, they're leverage, but that wasn't the point.

If controlling overall portfolio volatility is your goal, risk parity portfolios are designed for that.
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Re: Inflation Hedge by buying options on TIP

Post by Astones »

skierincolorado wrote: Tue May 04, 2021 12:26 am
watchnerd wrote: Tue May 04, 2021 12:23 am
skierincolorado wrote: Tue May 04, 2021 12:19 am

Oh it's not free at all. You'd be allocating capital to something with an expected return of near zero. In return, your portfolio would experience less volatility. And the long-term return would be reduced by the return you could have achieved investing the same capital in stocks.
If you're just trying to reduce volatility, why not use leverage to implement a risk parity strategy?
That's what deep in the money options are, leverage. Usually it's cheaper leverage than what the broker offers. Box spread will be cheaper, but this is simpler.

Control $126.70 of TIP with $7.30 in capital at a <1.6% financing cost. I say 'less than' because part of the 1.6% you are paying is downside protection (you stop losing if TIP goes below the strike of 120).
How much would you allocate to the TIP options and what allocation would you have otherwise?
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Re: Inflation Hedge by buying options on TIP

Post by firebirdparts »

How far out in the future can you buy an option? This clearly only works if there's a surprise. You'd like to leave plenty of time for the surprise to happen, by definition.
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Re: Inflation Hedge by buying options on TIP

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firebirdparts wrote: Tue May 04, 2021 8:45 am How far out in the future can you buy an option? This clearly only works if there's a surprise. You'd like to leave plenty of time for the surprise to happen, by definition.
I can't imagine a likely surprise so big that TIPS options are the choice you'd want, anyway.

Commodities have far higher beta and extend their 'inflation coverage umbrella' wider than TIPS, according to the paper by Vanguard.

For protecting a whole port, I'd pick a different tool for this task than TIPS options.

And for mild unexpected inflation, if you're protecting stocks -- who cares? Stocks will be fine if inflation comes in at 2.7% in the next 5 years instead of the expected 2.6%.
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Re: Inflation Hedge by buying options on TIP

Post by skierincolorado »

watchnerd wrote: Tue May 04, 2021 8:07 am
skierincolorado wrote: Tue May 04, 2021 12:26 am

That's what deep in the money options are, leverage. Usually it's cheaper leverage than what the broker offers. Box spread will be cheaper, but this is simpler.

Control $126.70 of TIP with $7.30 in capital at a <1.6% financing cost. I say 'less than' because part of the 1.6% you are paying is downside protection (you stop losing if TIP goes below the strike of 120).
Yes, they're leverage, but that wasn't the point.

If controlling overall portfolio volatility is your goal, risk parity portfolios are designed for that.
And I believe risk parity often includes TIPS. This is another way to do that with leverage and reasonable finance costs.
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Re: Inflation Hedge by buying options on TIP

Post by skierincolorado »

firebirdparts wrote: Tue May 04, 2021 8:45 am How far out in the future can you buy an option? This clearly only works if there's a surprise. You'd like to leave plenty of time for the surprise to happen, by definition.
TIP was the only etf that had more than zero options liquidity. Still low. The farthest contract was two years. But it was more expensive. The one year seemed best to me. Not really recommending this unless someone really is already leveraged and doesn’t want to bother with box spreads that would be cheaper.
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Re: Inflation Hedge by buying options on TIP

Post by skierincolorado »

watchnerd wrote: Tue May 04, 2021 8:53 am
firebirdparts wrote: Tue May 04, 2021 8:45 am How far out in the future can you buy an option? This clearly only works if there's a surprise. You'd like to leave plenty of time for the surprise to happen, by definition.
I can't imagine a likely surprise so big that TIPS options are the choice you'd want, anyway.

Commodities have far higher beta and extend their 'inflation coverage umbrella' wider than TIPS, according to the paper by Vanguard.

For protecting a whole port, I'd pick a different tool for this task than TIPS options.

And for mild unexpected inflation, if you're protecting stocks -- who cares? Stocks will be fine if inflation comes in at 2.7% in the next 5 years instead of the expected 2.6%.
Because the options are deep in the money but still highly leveraged 18x, you’d make significant money from even a small inflation surprise.
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Re: Inflation Hedge by buying options on TIP

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skierincolorado wrote: Tue May 04, 2021 9:06 am And I believe risk parity often includes TIPS. This is another way to do that with leverage and reasonable finance costs.
RPAR includes a miniscule 2.97% to TIPS.

17% is gold, which will be their real inflation play.

And that makes sense, given its higher beta.

But again...that's not really the point.

Inflation isn't a major source of portfolio volatility for a high equity port, so if volatility reduction is your major goal, leaning hard on inflation seems weird.
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Re: Inflation Hedge by buying options on TIP

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skierincolorado wrote: Mon May 03, 2021 11:40 pmTIPS are pretty unique in that they are the only instrument that directly hedges changes in inflation expectations. (underline added)
TIPS hedge against actual inflation, not against expected inflation. If expected inflation rises, TIPS prices will not rise unless real interest rates fall at the same time. When inflation expectations rise, all we know is that the yield difference between TIPS and nominal Treasuries of the same maturity will increase. We don't know that TIPS yields will necessarily fall, and that's what's needed for their prices to rise.
skierincolorado wrote: Tue May 04, 2021 12:05 amYou also need to subtract any distributions the fund made because owning an option you don't get those distributions. Those distributions have averaged 1.1%/year recently [for the TIP ETF].
That's a problem with your plan, skierincolorado. Yes, if actual inflation rises, the nominal return of a TIPS fund will also rise. But the effect of the higher inflation (i.e., the inflation adjustment to principal) must be paid out in dividends. Therefore, the increase in actual inflation will only cause the fund's price to rise until the next dividend distribution. And the TIP ETF pays dividends monthly. With a sustained rise of X% in the CPI, the distribution yield will also rise X%. [*]

* I need to qualify that. Income dividends for a TIPS fund include the interest income plus increases in the inflation adjustment. Interest income is coupon payments plus accretion of bond discount less amortization of bond premium. Currently TIPS yields are so negative that amortization of bond premium probably swamps coupon payments plus accretion of bond discount, making interest income a negative value. Therefore the inflation adjustment must be a certain level or there won't be any dividends at all. But once the inflation adjustment reaches that level, any further increase will flow through completely into dividends.
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Re: Inflation Hedge by buying options on TIP

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#Cruncher wrote: Wed May 05, 2021 6:13 am
skierincolorado wrote: Mon May 03, 2021 11:40 pmTIPS are pretty unique in that they are the only instrument that directly hedges changes in inflation expectations. (underline added)
TIPS hedge against actual inflation, not against expected inflation. If expected inflation rises, TIPS prices will not rise unless real interest rates fall at the same time. When inflation expectations rise, all we know is that the yield difference between TIPS and nominal Treasuries of the same maturity will increase. We don't know that TIPS yields will necessarily fall, and that's what's needed for their prices to rise.

skierincolorado wrote: Tue May 04, 2021 12:05 amYou also need to subtract any distributions the fund made because owning an option you don't get those distributions. Those distributions have averaged 1.1%/year recently [for the TIP ETF].
That's a problem with your plan, skierincolorado. Yes, if actual inflation rises, the nominal return of a TIPS fund will also rise. But the effect of the higher inflation (i.e., the inflation adjustment to principal) must be paid out in dividends. Therefore, the increase in actual inflation will only cause the fund's price to rise until the next dividend distribution. And the TIP ETF pays dividends monthly. With a sustained rise of X% in the CPI, the distribution yield will also rise X%. [*]

* I need to qualify that. Income dividends for a TIPS fund include the interest income plus increases in the inflation adjustment. Interest income is coupon payments plus accretion of bond discount less amortization of bond premium. Currently TIPS yields are so negative that amortization of bond premium probably swamps coupon payments plus accretion of bond discount, making interest income a negative value. Therefore the inflation adjustment must be a certain level or there won't be any dividends at all. But once the inflation adjustment reaches that level, any further increase will flow through completely into dividends.
This is false. TIPS move in price with changes in expected inflation. They are actively traded instruments and obviously investors will pay more for a tip if their inflation expectations change. TIPS have had huge returns the last six months even though actual inflation is still low and interest rates are rising.

The fund doesn’t pay out these unrealized capital gains. They only pay out the dividends and the capital gains that are realized when they roll into later maturities. The price of the tip etf has gone up significantly in the last few months and 25% since 2008.
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Re: Inflation Hedge by buying options on TIP

Post by BJJ_GUY »

skierincolorado wrote: Wed May 05, 2021 9:48 am
#Cruncher wrote: Wed May 05, 2021 6:13 am
skierincolorado wrote: Mon May 03, 2021 11:40 pmTIPS are pretty unique in that they are the only instrument that directly hedges changes in inflation expectations. (underline added)
TIPS hedge against actual inflation, not against expected inflation. If expected inflation rises, TIPS prices will not rise unless real interest rates fall at the same time. When inflation expectations rise, all we know is that the yield difference between TIPS and nominal Treasuries of the same maturity will increase. We don't know that TIPS yields will necessarily fall, and that's what's needed for their prices to rise.

skierincolorado wrote: Tue May 04, 2021 12:05 amYou also need to subtract any distributions the fund made because owning an option you don't get those distributions. Those distributions have averaged 1.1%/year recently [for the TIP ETF].
That's a problem with your plan, skierincolorado. Yes, if actual inflation rises, the nominal return of a TIPS fund will also rise. But the effect of the higher inflation (i.e., the inflation adjustment to principal) must be paid out in dividends. Therefore, the increase in actual inflation will only cause the fund's price to rise until the next dividend distribution. And the TIP ETF pays dividends monthly. With a sustained rise of X% in the CPI, the distribution yield will also rise X%. [*]

* I need to qualify that. Income dividends for a TIPS fund include the interest income plus increases in the inflation adjustment. Interest income is coupon payments plus accretion of bond discount less amortization of bond premium. Currently TIPS yields are so negative that amortization of bond premium probably swamps coupon payments plus accretion of bond discount, making interest income a negative value. Therefore the inflation adjustment must be a certain level or there won't be any dividends at all. But once the inflation adjustment reaches that level, any further increase will flow through completely into dividends.
This is false. TIPS move in price with changes in expected inflation. They are actively traded instruments and obviously investors will pay more for a tip if their inflation expectations change. TIPS have had huge returns the last six months even though actual inflation is still low and interest rates are rising.

The fund doesn’t pay out these unrealized capital gains. They only pay out the dividends and the capital gains that are realized when they roll into later maturities. The price of the tip etf has gone up significantly in the last few months and 25% since 2008.
TIPS are linked to CPI, which is used to define current prices. Sure, TIPS can trade based on supply/demand, and that may well take into account expectations, but that's the same as any financial instrument. The statement you made is not correct 'TIPS are pretty unique in that they are the only instrument that directly hedges changes in inflation.'

If you could trade interest rate swaps, this would be a way of accessing something closer to 'direct exposure' to inflation expectations. Not only are rate swaps a more direct expression of expected future rates, but you also avoid the dependence on the governments calculation of CPI which has become pretty flawed in the last 1-2 decades (another reason I'd be hesitant about thinking TIPS are such a strong inflation hedging instrument, but that's for a different discussion, I presume).
Topic Author
skierincolorado
Posts: 66
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Re: Inflation Hedge by buying options on TIP

Post by skierincolorado »

BJJ_GUY wrote: Wed May 05, 2021 12:29 pm
skierincolorado wrote: Wed May 05, 2021 9:48 am
#Cruncher wrote: Wed May 05, 2021 6:13 am
skierincolorado wrote: Mon May 03, 2021 11:40 pmTIPS are pretty unique in that they are the only instrument that directly hedges changes in inflation expectations. (underline added)
TIPS hedge against actual inflation, not against expected inflation. If expected inflation rises, TIPS prices will not rise unless real interest rates fall at the same time. When inflation expectations rise, all we know is that the yield difference between TIPS and nominal Treasuries of the same maturity will increase. We don't know that TIPS yields will necessarily fall, and that's what's needed for their prices to rise.

skierincolorado wrote: Tue May 04, 2021 12:05 amYou also need to subtract any distributions the fund made because owning an option you don't get those distributions. Those distributions have averaged 1.1%/year recently [for the TIP ETF].
That's a problem with your plan, skierincolorado. Yes, if actual inflation rises, the nominal return of a TIPS fund will also rise. But the effect of the higher inflation (i.e., the inflation adjustment to principal) must be paid out in dividends. Therefore, the increase in actual inflation will only cause the fund's price to rise until the next dividend distribution. And the TIP ETF pays dividends monthly. With a sustained rise of X% in the CPI, the distribution yield will also rise X%. [*]

* I need to qualify that. Income dividends for a TIPS fund include the interest income plus increases in the inflation adjustment. Interest income is coupon payments plus accretion of bond discount less amortization of bond premium. Currently TIPS yields are so negative that amortization of bond premium probably swamps coupon payments plus accretion of bond discount, making interest income a negative value. Therefore the inflation adjustment must be a certain level or there won't be any dividends at all. But once the inflation adjustment reaches that level, any further increase will flow through completely into dividends.
This is false. TIPS move in price with changes in expected inflation. They are actively traded instruments and obviously investors will pay more for a tip if their inflation expectations change. TIPS have had huge returns the last six months even though actual inflation is still low and interest rates are rising.

The fund doesn’t pay out these unrealized capital gains. They only pay out the dividends and the capital gains that are realized when they roll into later maturities. The price of the tip etf has gone up significantly in the last few months and 25% since 2008.
TIPS are linked to CPI, which is used to define current prices. Sure, TIPS can trade based on supply/demand, and that may well take into account expectations, but that's the same as any financial instrument. The statement you made is not correct 'TIPS are pretty unique in that they are the only instrument that directly hedges changes in inflation.'

If you could trade interest rate swaps, this would be a way of accessing something closer to 'direct exposure' to inflation expectations. Not only are rate swaps a more direct expression of expected future rates, but you also avoid the dependence on the governments calculation of CPI which has become pretty flawed in the last 1-2 decades (another reason I'd be hesitant about thinking TIPS are such a strong inflation hedging instrument, but that's for a different discussion, I presume).
I think we are partially talking past each other and actually agree. If inflation expectations go up, either nominal yields will rise, or real yields will fall, or both. I think we are on the same page as that. You're probably right that if all else was held constant (whatever that means) and inflation expectations went up, real yields would be unchanged and nominal rates would rise. But I could argue that realistically it would be some of both, because the nominal yield market is an order of magnitude bigger and has a direct effect on personal finances, mortgage market, corporate finances etc.. a large nominal rate increase due to rising inflation expectations would very likely also be buffered by falling real yields. With the amount of indebtedness, significant rising nominal rates would be too disruptive if it occurred in a short or medium time frame.

Inflation expectations are by definition the difference between nominal and real yields. If inflation expectations go up, who's to say whether it's nominal yields that will rise, or real yields that fall?
BJJ_GUY
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Re: Inflation Hedge by buying options on TIP

Post by BJJ_GUY »

skierincolorado wrote: Wed May 05, 2021 5:33 pm
BJJ_GUY wrote: Wed May 05, 2021 12:29 pm
TIPS are linked to CPI, which is used to define current prices. Sure, TIPS can trade based on supply/demand, and that may well take into account expectations, but that's the same as any financial instrument. The statement you made is not correct 'TIPS are pretty unique in that they are the only instrument that directly hedges changes in inflation.'

If you could trade interest rate swaps, this would be a way of accessing something closer to 'direct exposure' to inflation expectations. Not only are rate swaps a more direct expression of expected future rates, but you also avoid the dependence on the governments calculation of CPI which has become pretty flawed in the last 1-2 decades (another reason I'd be hesitant about thinking TIPS are such a strong inflation hedging instrument, but that's for a different discussion, I presume).
I think we are partially talking past each other and actually agree. If inflation expectations go up, either nominal yields will rise, or real yields will fall, or both. I think we are on the same page as that. You're probably right that if all else was held constant (whatever that means) and inflation expectations went up, real yields would be unchanged and nominal rates would rise. But I could argue that realistically it would be some of both, because the nominal yield market is an order of magnitude bigger and has a direct effect on personal finances, mortgage market, corporate finances etc.. a large nominal rate increase due to rising inflation expectations would very likely also be buffered by falling real yields. With the amount of indebtedness, significant rising nominal rates would be too disruptive if it occurred in a short or medium time frame.

Inflation expectations are by definition the difference between nominal and real yields. If inflation expectations go up, who's to say whether it's nominal yields that will rise, or real yields that fall?
Yes, we are talking about related but not exactly the same thing, perhaps. I get the cause/effect scenarios you are outlining, and I don't disagree, but only in the abstract. As it relates to the market, broadly, I'm with you.

The problem is that most people are already invested, so when yields change, they're experiencing mark-to-market changes and not truly capturing the yield change (like a brand new investor would if they were buying on-the-run bonds that suddenly had a higher YTM).

So the point I was trying to make is probably easiest to think about if we assume an investment of just one TIPS bond. If I were to hold that bond until maturity, the only thing that would alter my total return over the course of investment is directly linked to changes in CPI. Intermittent mark-to-market changes are certainly a reaction to market expectations (and technicals etc.), but all that price fluctuation doesn't really change the return of that particular bond. So, at the most fundamental level, TIPS return is linked to trailing 'inflation' (CPI) and not a great way of gaining exposure to expected changes in rates and/or inflation.
Topic Author
skierincolorado
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Re: Inflation Hedge by buying options on TIP

Post by skierincolorado »

BJJ_GUY wrote: Wed May 05, 2021 5:58 pm
skierincolorado wrote: Wed May 05, 2021 5:33 pm
BJJ_GUY wrote: Wed May 05, 2021 12:29 pm
TIPS are linked to CPI, which is used to define current prices. Sure, TIPS can trade based on supply/demand, and that may well take into account expectations, but that's the same as any financial instrument. The statement you made is not correct 'TIPS are pretty unique in that they are the only instrument that directly hedges changes in inflation.'

If you could trade interest rate swaps, this would be a way of accessing something closer to 'direct exposure' to inflation expectations. Not only are rate swaps a more direct expression of expected future rates, but you also avoid the dependence on the governments calculation of CPI which has become pretty flawed in the last 1-2 decades (another reason I'd be hesitant about thinking TIPS are such a strong inflation hedging instrument, but that's for a different discussion, I presume).
I think we are partially talking past each other and actually agree. If inflation expectations go up, either nominal yields will rise, or real yields will fall, or both. I think we are on the same page as that. You're probably right that if all else was held constant (whatever that means) and inflation expectations went up, real yields would be unchanged and nominal rates would rise. But I could argue that realistically it would be some of both, because the nominal yield market is an order of magnitude bigger and has a direct effect on personal finances, mortgage market, corporate finances etc.. a large nominal rate increase due to rising inflation expectations would very likely also be buffered by falling real yields. With the amount of indebtedness, significant rising nominal rates would be too disruptive if it occurred in a short or medium time frame.

Inflation expectations are by definition the difference between nominal and real yields. If inflation expectations go up, who's to say whether it's nominal yields that will rise, or real yields that fall?
Yes, we are talking about related but not exactly the same thing, perhaps. I get the cause/effect scenarios you are outlining, and I don't disagree, but only in the abstract. As it relates to the market, broadly, I'm with you.

The problem is that most people are already invested, so when yields change, they're experiencing mark-to-market changes and not truly capturing the yield change (like a brand new investor would if they were buying on-the-run bonds that suddenly had a higher YTM).

So the point I was trying to make is probably easiest to think about if we assume an investment of just one TIPS bond. If I were to hold that bond until maturity, the only thing that would alter my total return over the course of investment is directly linked to changes in CPI. Intermittent mark-to-market changes are certainly a reaction to market expectations (and technicals etc.), but all that price fluctuation doesn't really change the return of that particular bond. So, at the most fundamental level, TIPS return is linked to trailing 'inflation' (CPI) and not a great way of gaining exposure to expected changes in rates and/or inflation.
Barring default, that's true of all bonds: the return is just whatever yield you signed up for when you bought it, and in the case of TIPS any actual CPI adjustment you get. But part of the benefit of bonds in risk parity would be the MTM and rebalancing. Also I take your point that in the end all that will have mattered is the actual CPI, but of course there is a relationship between changes in expected and actual CPI. But the price changes when the expectation changes. If the new expectation is wrong and actual ends up being less, then eventually the expectation will shift back down. If you own 10 or 30 year TIPS, and the FED changes its inflation stance, or we just enter a high inflation environment or whatever, you don't have to wait 10 or 30 years to get the return on the TIPS. They will already be worth significantly more, as we saw recently with rising inflation expectations/falling real rates.
BJJ_GUY
Posts: 635
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Re: Inflation Hedge by buying options on TIP

Post by BJJ_GUY »

skierincolorado wrote: Thu May 06, 2021 12:11 pm Barring default, that's true of all bonds: the return is just whatever yield you signed up for when you bought it, and in the case of TIPS any actual CPI adjustment you get. But part of the benefit of bonds in risk parity would be the MTM and rebalancing. Also I take your point that in the end all that will have mattered is the actual CPI, but of course there is a relationship between changes in expected and actual CPI. But the price changes when the expectation changes. If the new expectation is wrong and actual ends up being less, then eventually the expectation will shift back down. If you own 10 or 30 year TIPS, and the FED changes its inflation stance, or we just enter a high inflation environment or whatever, you don't have to wait 10 or 30 years to get the return on the TIPS. They will already be worth significantly more, as we saw recently with rising inflation expectations/falling real rates.
I suppose you can make this case, but this is not something that can be relied upon as a rule. More often than not, you'd anticipate rising inflation to be associated with rising rates. While demand for TIPS can certainly increase the price, you have to also account for the bond's duration. Interest rate sensitivity often counterbalances what seems like a one way street for the price of TIPS when CPI is rising.
corp_sharecropper
Posts: 515
Joined: Thu Nov 07, 2013 2:36 pm

Re: Inflation Hedge by buying options on TIP

Post by corp_sharecropper »

watchnerd wrote: Tue May 04, 2021 9:17 am
skierincolorado wrote: Tue May 04, 2021 9:06 am And I believe risk parity often includes TIPS. This is another way to do that with leverage and reasonable finance costs.
RPAR includes a miniscule 2.97% to TIPS.

17% is gold, which will be their real inflation play.

And that makes sense, given its higher beta.

But again...that's not really the point.

Inflation isn't a major source of portfolio volatility for a high equity port, so if volatility reduction is your major goal, leaning hard on inflation seems weird.
Rpar has 20%, I'm guessing you got your numbers from a source that doesn't properly account for notional value of futures contracts.


Capital Allocation:
12.5% US Equities
5% Developed ex-US Equities
7.5% Emerging Markets Equities
15% Commodity Producers
17.5% Gold
20% TIPS
10% Cash*
======================
100% Total
*Cash/Tbills collateral for treasury futures

Notional Exposure:
12.5% US Equities
5% Developed ex-US Equities
7.5% Emerging Markets Equities
15% Commodity Producers
17.5% Gold
20% TIPS
42.5% Treasuries
=======================
120% Total
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