This article first appeared in the May issue of
/ WealthManagement.com. Brad Zigler's articles can also be found
Alternative Insights e-Letter
In April the central bank of Cyprus announced it would sell off
three-quarters of its gold reserves, some 10 metric tons, to fund
the bailout of its financial system. That's the largest bullion
sale by a eurozone nation since France sold 17 metric tons in
Not surprisingly, gold investors were rattled by the Cypriot
declaration and ominous remarks made by European Central Bank
president Mario Draghi shook them even more. Holders of gold
assets, worried about the potential for copycat sales by other
debt-plagued countries such as Italy, Portugal, Spain and Greece,
sent gold prices into a liquidation tailspin.
Up until then, central banks were more inclined to buy metal
rather than sell it. The dedication of state reserves to bullion
had kept a bid under the gold price. No wonder the Cyprus
was deemed bearish.
Overlay on this some feeble job growth, a downward move in the
ISM Purchasing Managers Index and a significant drop in the
wholesale inflation rate and some are fearing the specter of
Over the past decade, a plethora of exchange-traded products
(ETPs) have been floated offering investors inflation hedges.
Nearly two dozen funds and notes tied to inflation-protected
securities alone have been launched since 2003 and more are on the
But funds providing portfolio protection against the ravages of
deflation is smaller and not well understood. Given the recent
sell-off, it's worth taking a look at funds that can help investors
circumnavigate the shoals of a disinflationary economy.
Playing the deflation game
We'll start with the the one actually branded with the word
PowerShares DB US Deflation ETNs (
The fund is made ofsenior unsecured obligations issued by A+ rated
Deutsche Bank AG and are based on the DBIQ Duration-Adjusted
Deflation Index. The index tracks changes in market expectations of
future inflation implied by the spread between Treasury
Inflation-Protected Securities ((
)) and U.S. Treasury bonds.
Unlike fixed-coupon Treasuries, TIPS offer investors a variable
return tied to the Consumer Price Index ((
)). Interest is paid semi-annually in the same manner as
conventional paper, but the TIPS principal value adjusts up and
down based on the inflation metric. Thus, an investor's actual
yield is based on the TIPS's adjusted principal.
When inflation is held in check, the TIPS return can be
expressed negatively. At the end of March, for example, ten-year
TIPS were priced at a discount to the prevailing inflation
One way to gauge the relative worth of TIPS is to calculate the
"breakeven inflation rate" ((BEI)). BEI is the spread between a
TIPS yield and that of a Treasury note with a similar maturity.
When inflation lingers above the BEI, TIPS are likely to outperform
conventional T-notes, but when the CPI trends below BEI,
traditional Treasuries will better TIPS.
BEI can be easily gamed by sophisticated traders. To play on an
expectation of disinflation or deflation, for example, one could
sell TIPS short against a long position in conventional Treasury
bonds. The index driving DEFL's value simulates this very trade by
notionally selling TIPS and buying Treasury futures across the
BEI declines when Treasury yields decrease (and prices, as a
consequence, increase) relative to the yield on TIPS. An exemplar
is the market crash of 2008. In early July, ten-year Treasuries
were offered at 3.99 percent while TIPS with a similar maturity
yielded 1.42 percent, resulting in a BEI of 2.57 percent. By
November, T-note rates had slipped to 3.20 percent and TIPS were at
3.15 percent. Thus the BEI came in more than 250 basis points (to
0.05 percent) as the U.S. economy scraped bottom following a
deflationary nosedive (see Chart 1).
Unfortunately, DEFL wasn't available as a hedge in 2008. The
notes were floated late in 2011, well after BEI rebounded to the
two percent level. Then a couple of
, also designed to play BEI from the short side, debuted (see Table
ProShares UltraPro Short 10 Year TIPS/TSY Spread (
launched in February 2012, is designed to provide owners with three
times the inverse daily performance of the Dow Jones Credit Suisse
10-Year Inflation Breakeven Index. The index mirrors the
performance of long positions in the most recently issued ten-year
TIPS and duration-adjusted short positions in Treasury notes of
similar maturity. Rather than using actual TIPS and bond futures,
SINF obtains its exposures through swaps issued by money center
banks such as Citibank and Credit Suisse.
Further up the maturity ladder (and the duration risk spectrum),
ProShares Short 30 Year TIPS/TSY Spread
tracks the inverse daily performance of the Dow Jones Credit Suisse
30-Year Inflation Breakeven Index. Like SINF, proxies for the most
recently issued on-the-run 30-year TIPS and Treasury bonds populate
the underlying portfolio.
If you're scratching your head wondering why the fund playing
the ten-year spread is levered 3-to-1 while the 30-year product is
not geared, it's because of the difference in duration risk between
the maturity buckets. Longer-dated paper is much more sensitive to
interest rate risk. Cranking up the exposure of the ten-year spread
allows it to deliver the same bang for the buck as the fund based
on the trade in 30-year bonds (see Chart 2).
Spreads not required
Some investors might wonder why they should bet on deflation
through a two-legged trade when they can just short TIPS
themselves. For those who want to keep things simple, there's the
ProShares UltraShort TIPS
which attempts to provide two times the inverse daily performance
of the Barclays U.S. Treasury Inflation Protected Securities
Index constituents include all publicly issued TIPS with at
least one year remaining maturity and more than $250 million par
value outstanding. The index is weighted by relative market
As with the other ProShares products, TPS's index exposure is
obtained through swaps rather than physical replication.
Investors should know about the costs of using TPS in lieu of
the spread products. First, TPS is more expensive. Its annual
expense ratio is 95 basis points, 20 bips more than the other ETPs.
Then there's the performance cost. Since inception, TPS's value has
eroded at a nine percent annual clip, double the loss sustained by
the spread products. Is it then more likely that TPS will
outperform to the upside in a deflationary environment? Given the
fund's relatively low standard deviation, it doesn't seem
The spread products, in fact, appear to be bottoming off a base
established in February (see Chart 2). TPS hasn't yet signaled an
end to its downtrend.
No matter what product you consider, one thing is clear. They've
all been, to date, very lightly traded. As a group, their average
daily volume barely amounts to 2,400 shares, with most of the
business flowing to TPS. The light volume, no doubt, contributes to
some wide discounts and premiums to the ETPs' repurchase or net
asset values. While the discount/premium for each product seems
relatively mild (SINF is the worst with a median discount of 13
basis points) the day-to-day range can be quite wide. DEFL's benign
two-bip premium belies the fact that the closing price has skewed
as much as 3.4 percent on either side of the ETN's daily repurchase
value. You get a better sense of these premiums and discounts by
keeping an eye on their standard deviations. By this measure, the
widest variance is found in TPS pricing.
Overall these funds seem to have built a base and are poised to
deliver some degree of hedge protection if the expectations of
deflation rise. Whether or not an allocation to a deflation hedge
is justified is, of course, a very personal decision based upon the
sensitivity of one's portfolio and the deflationary outlook. For
these investors, it may be enough to know that the hedges are
available if needed.
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