Morgan Stanley interest rate strategist Anton Heese's latest note to clients comes with an ominous warning in its title: "There's a Storm Coming."
Heese is referring to the market for Treasury Inflation Protected Securities, or TIPS. This class of government bonds – inflation-linked securities – was a clear outperformer in 2012. Heese points out that the Barclays World Government Inflation Bond index gained about 7 percent in returns last year, while Treasuries only returned 2.1 percent, Bunds rose 4.5 percent, and Gilts gained 2.8 percent.
Now, inflation-linked bonds – like Treasury Inflation-Protected Securities (TIPS) in the United States – are looking pretty expensive too, and that has Heese convinced that there is a storm coming in the TIPS market.
Of the major inflation markets, we think TIPS are most at risk if absolute returns deteriorate. This is because a large portion of the market is held in mutual funds, for which a strong investment performance is important for attracting and retaining assets.
By contrast, the majority of European linkers, especially in the UK, are owned by pension funds, as hedging assets against inflation-linked liabilities. In fact, a substantial back-up in yields may generate a significant increase in investor interest in UKTis and euro linkers, as schemes that were previously reluctant to de-risk their portfolios because their solvency ratios were too low, may find themselves able to afford inflation bonds.
The TIPS market, by contrast, may find itself in a vicious spiral if poor returns result in outflows, forcing fund managers to liquidate positions to generate cash, leading to more selling pressure and further poor returns. At present, it is not clear who the alternative investor in TIPS is likely to be, unless yields rise substantially.
The warning stems from Heese's trading call on TIPS. He says that yields on TIPS are an excellent predictor of future returns – when investors buy them up, like they did in 2012, and drive yields down, the space usually languishes thereafter.
So, given how low yields on TIPS are now, based on model projections, Heese expects the TIPS market to average only 1 percent in returns per year for the next three years.
And that is actually worse than it sounds, according to Heese, who writes, "This forecast looks more dreary than dreadful, but the risk is that the low 3-year average may be due to significantly negative returns in at least one of the next 3 years rather than very modest returns throughout."
Hence, the storm.
More From Business Insider
- We Could See A Bond Market 'Coup' During Today's Treasury Auction
- A Crazy Chinese Deep Freeze Is Causing Vegetable Prices To Surge [PHOTOS]
- CHART: Inflation Since 1775 And How It Took Off In 1933
- Investment & Company Information