As the Federal Reserve is expected to embark on the journey to normalize interest rates, five-year U.S. Treasury real yields have finally moved back into positive territory. After many years of financial repression ‒ interest rates on savings below the rate of inflation ‒ investors can now take advantage of this opportunity in an actively managed portfolio. To that end, PIMCO offers the Real Return Limited Duration Strategy, the lower-duration sister to PIMCO’s flagship Real Return Strategy.
Higher short-term real yields make investing in a short-duration portfolio of Treasury Inflation-Protected Securities (TIPS) more attractive now than during most of the past five years. In addition to more attractive real yields, inflation expectations, which are expressed in the “breakeven rate”– the difference between the yield on TIPS and the yield on a comparable nominal U.S. Treasury bond – are near record lows; all else being equal, the lower the inflation expectations, the greater the chance that inflation will come in higher and the total returns on TIPS can exceed expectations (Figure 2).
Today, short-term TIPS can offer inexpensive hedging against various sources of potential future inflation, like a global increase in monetary easing or a rebound in commodity prices.
Falling commodity prices have been the main reason why headline inflation has remained so low recently. But at today’s depressed levels, commodity prices actually pose a concern for future inflation. Within a little over a year, commodities have lost about 35% in value, reaching levels we haven’t seen for over a decade (Figure 3). Even though we believe a repeat of the commodity super-cycle of the mid-2000s is unlikely, we also believe that current depressed commodity prices are unsustainable and will incur a supply response through a reduction in capital expenditure – ultimately leading back
to a more balanced market and higher prices.
The potential benefits of investing in lower-duration TIPS
Because of their lower duration, shorter-term TIPS naturally have lower interest rate sensitivity and lower volatility than longer-term TIPS. Shorter-duration TIPS have another important potential benefit for investors: Their returns tend to have a higher correlation to both absolute levels of inflation and changes in inflation compared to their longer-duration counterparts (Figure 4). While principal on all TIPS adjusts one-for-one with realized inflation (based on the Consumer Price Index, or CPI), total returns on TIPS are also influenced by changes in real yields. This effect can temporarily “dilute” the direct linkage between CPI and TIPS returns and is more pronounced with longer-duration TIPS. Because lower-duration TIPS are less affected, they tend to have a higher correlation to realized CPI.
Of course, there are trade-offs between short- and full-duration TIPS. The longer-duration TIPS index offers both higher real yields, as investors can earn
a higher term premium, and more protection from changes in inflation expectations (rather than realized inflation). For example, when inflation
expectations increase (breakeven rates widen or rise), the greater the potential benefit for portfolios with more breakeven (TIPS) duration.
Why index selection matters in low-duration TIPS accounts
For the Real Return Limited Duration Strategy, we have chosen the Barclays 1-5 year TIPS index as our benchmark rather than a 0-5 year index because we
believe TIPS with slightly higher maturities offer investors better inflation hedging. For TIPS with maturities of less than a year, and especially less
than three months, inflation hedging is significantly reduced due to the two-to-three-month time lag between the CPI printing and its accrual to TIPS; in
the final two to three months before maturity, TIPS therefore tend to trade much like nominal Treasury bonds without any linkage to CPI. By focusing on the
one-to-five-year segment and avoiding these ultra-short TIPS, every single TIPS in the index can benefit from increases in CPI.
Adding value in managing low-duration TIPS
The PIMCO Real Return Limited Duration Strategy is designed to fully benefit from the same active TIPS management we employ in the PIMCO Real Return
Strategy: It is managed by the same portfolio management team and leverages PIMCO’s time-tested investment process and global resources in an effort to
successfully navigate the world of inflation-linked bonds (see Figure 5).
Because low-duration TIPS tend to have a higher correlation to headline CPI, accurately anticipating headline CPI is a crucial piece in managing short TIPS
to generate value for investors. PIMCO’s unique integrated real return desk, which intrinsically combines inflation-linked bond management with commodities
management, has allowed us to build more robust bottom-up inflation models, recognizing that commodity price changes are responsible for most of the
changes in headline CPI.
Figure 6 illustrates the importance food and energy prices play in any changes to CPI. Even though food and energy costs represent only about a quarter of the overall consumption basket, the two categories have been responsible for over 80% of the volatility in CPI.
As investors prepare for rising rates and a potential rise in inflation in the U.S, PIMCO’s Real Return Limited Duration Strategy seeks to provide lower
structural interest rate sensitivity while maintaining a full inflation hedge. By focusing on TIPS in the one- to five-year segment, the strategy offers a
high correlation to realized CPI, and aims to take advantage of today’s positive real yields combined with attractively priced inflation expectations.
PIMCO’s Real Return Limited Duration Strategy is also designed to benefit from the same time-tested investment process and portfolio management team as
PIMCO’s flagship Real Return Strategy.
Investors should consider the investment objectives, risks, charges and expenses of the funds carefully before investing. This and other information
are contained in the fund’s prospectus and summary prospectus, if available, which may be obtained by contacting your investment professional or PIMCO
representative or by visiting www.pimco.com. Please read them carefully before you invest or send money.