Wednesday, November 11, 2009
Bond Buccaneer Bleg: Murphy vs. Sumner
Do any of the esteemed Free Advice readers have experience with the bond market? I don't mean, "Did you know that price and yield move in opposite directions?" I mean, do you really understand bond math etc.?
I ask because Scott Sumner and I are launching volleys at each other (he from his ivory tower, me from my armchair), and we're stuck on a fairly crucial point. Here he gives a lengthy rebuttal (or it might be a rejoinder at this point, I've lost track) to my response to his "Does Macro Need a New Paradigm?" post.
(BTW I am having trouble logging on to Free Advice this morning. Is it because I'm getting mad hits from Sumner's link? I don't know whether to hope for that or not. I.e. I'm going to be annoyed if I start to hit the big time and learn that my host can't handle it.)
Anyway one of the key issues is that Sumner claims the massive spike in the TIPS yield (in fall 2008) could be due to a collapse in inflation expectations. I thought "no way!" because by definition the TIPS yields aren't supposed to be affected by price inflation concerns.
Scott said yes that's true for newly issued TIPS, but for "off the run" TIPS there would already have been a significant amount of pent up CPI hikes, which would then unwind (as it were) if investors expected the CPI to fall drastically from 2008 - 2010 let's say.
I thought that at best this effect would just cause a one-shot adjustment in the market price of older TIPS, so that the yield-to-maturity would be basically the same for older or newer TIPS. To bolster my case, I emailed Scott this graph, showing a 10-year TIPS and a 5-year TIPS, that both mature within 3 months of each other in early 2011. As you can see from the link, their yields were virtually identical on the way up, and then diverged only slightly coming back down.
Scott said that the picture is consistent with his thesis.
Thus we're once again stuck. Like all good economists, Scott and I can look at the same chart and say, "Yep, just like I predicted"--even though we totally disagree with each other.
Any help? Anyone?
I ask because Scott Sumner and I are launching volleys at each other (he from his ivory tower, me from my armchair), and we're stuck on a fairly crucial point. Here he gives a lengthy rebuttal (or it might be a rejoinder at this point, I've lost track) to my response to his "Does Macro Need a New Paradigm?" post.
(BTW I am having trouble logging on to Free Advice this morning. Is it because I'm getting mad hits from Sumner's link? I don't know whether to hope for that or not. I.e. I'm going to be annoyed if I start to hit the big time and learn that my host can't handle it.)
Anyway one of the key issues is that Sumner claims the massive spike in the TIPS yield (in fall 2008) could be due to a collapse in inflation expectations. I thought "no way!" because by definition the TIPS yields aren't supposed to be affected by price inflation concerns.
Scott said yes that's true for newly issued TIPS, but for "off the run" TIPS there would already have been a significant amount of pent up CPI hikes, which would then unwind (as it were) if investors expected the CPI to fall drastically from 2008 - 2010 let's say.
I thought that at best this effect would just cause a one-shot adjustment in the market price of older TIPS, so that the yield-to-maturity would be basically the same for older or newer TIPS. To bolster my case, I emailed Scott this graph, showing a 10-year TIPS and a 5-year TIPS, that both mature within 3 months of each other in early 2011. As you can see from the link, their yields were virtually identical on the way up, and then diverged only slightly coming back down.
Scott said that the picture is consistent with his thesis.
Thus we're once again stuck. Like all good economists, Scott and I can look at the same chart and say, "Yep, just like I predicted"--even though we totally disagree with each other.
Any help? Anyone?
Comments:
Could you try emailing Peter Schiff? He'd probably know about this stuff, and he'd probably be happy to help an adjunct scholar from the LvMI.
# posted by 
: November 11, 2009 11:28 AM
: November 11, 2009 11:28 AM
Only tangential to your question, Bob, but have anyone ever get rich investing in TIPS?
How important in the whole picture is the TIPS market anyway?
How important in the whole picture is the TIPS market anyway?
Isn't this argument just another reason to get rid of the Fed? No one can really know in advance all of the basic (and not so basic) effects of Fed policy. We are all sitting around making investment decisions based not upon consumer demand, but on how to best game the horrible system unleashed by dollar dilution.
# posted by : November 11, 2009 12:26 PM
: November 11, 2009 12:26 PM
Well, I can partially answer my own question. TIPS is 500 billions according to Wikipedia.
What's more fishy about calling the TIPS market... (dramatic pause, drums rolling) THE market, is that for a long time the TIPS was reserved for individual investors.
Yes, they have changed the rules on April 2009, which gives... I'd really like to know. Here are the remaining restrictions:
NOTE: Entity accounts are not available at this time for unincorporated associations, governmental organizations/officers, or tribal organizations.
If nothing else the limit of 5 million per investor per auction means that is not of interest for really big players.
What's more fishy about calling the TIPS market... (dramatic pause, drums rolling) THE market, is that for a long time the TIPS was reserved for individual investors.
Yes, they have changed the rules on April 2009, which gives... I'd really like to know. Here are the remaining restrictions:
NOTE: Entity accounts are not available at this time for unincorporated associations, governmental organizations/officers, or tribal organizations.
If nothing else the limit of 5 million per investor per auction means that is not of interest for really big players.
If engineers ran finance, they would never have allowed the "off the run" miscomparison to show up in any chart.
Silas,
I believe you, but I'm still not convinced the off-the-run thing is correct, at least not the way Scott is presenting it.
I have an even better chart to make my (circumstantial) case, but I'm waiting to talk to somebody official before announcing my complete devastation of the economist formerly known as Sumner.
I believe you, but I'm still not convinced the off-the-run thing is correct, at least not the way Scott is presenting it.
I have an even better chart to make my (circumstantial) case, but I'm waiting to talk to somebody official before announcing my complete devastation of the economist formerly known as Sumner.
I know Bob doesn't like amateurs having a go at stuff like this but what the heck I find it fun.
The way I see it is like this:
Ignoring coupon payments
In 2000 the treasury issues a TIPS for however much promising to pay the 2000 equivalent of $10,000 in 2010 dollars.
In 2005 a similar security is issued promising to pay the 2005 equivalent of $10,000 in 2010 dollars.
If there has been inflation thus far then the $10,000 equivalent of 2000 dollars in 2010 obviously already has a greater value than the $10,000 equivalent of 2005 dollars.
To demonstrate:
Lets say the treasury sold the 2005 bonds at a yield of 5% or so and that inflation expectations were for some positive change in CPI (it doesn't matter how much), so a bond purchased in 2005 would be for approximately $7,835. Then for how much would the bonds bought in 2000 sell for in 2005? Well assuming there has been 2% inflation year after year then you're buying not the $10,000 in 2005 dollar equivalent in 2010 but the $11,040 equivalent of 2005 dollars in 2010. Discounting this by 5% you get $8,650. Now I'm not sure how you'd report the yield on this. Of course if you look at it as just buying $10,000 in future money ignoring inflation effects you'd say the yield is 3% on the 2000 bonds while the yield is 5% on the 2005 bonds
However if at the time of purchase (of the 2005 TIPS) expectations were for a deflation rate of 2% or greater for the next 5 years then the price of the 2000 bonds would be the same as the 2005 ones cause all you're buying here when you buy either the TIPS from 2000 or the TIPS from 2005 is $10,000 in 2010 money because IIRC TIPS don't adjust for deflation.
So I think Scott is right.
The way I see it is like this:
Ignoring coupon payments
In 2000 the treasury issues a TIPS for however much promising to pay the 2000 equivalent of $10,000 in 2010 dollars.
In 2005 a similar security is issued promising to pay the 2005 equivalent of $10,000 in 2010 dollars.
If there has been inflation thus far then the $10,000 equivalent of 2000 dollars in 2010 obviously already has a greater value than the $10,000 equivalent of 2005 dollars.
To demonstrate:
Lets say the treasury sold the 2005 bonds at a yield of 5% or so and that inflation expectations were for some positive change in CPI (it doesn't matter how much), so a bond purchased in 2005 would be for approximately $7,835. Then for how much would the bonds bought in 2000 sell for in 2005? Well assuming there has been 2% inflation year after year then you're buying not the $10,000 in 2005 dollar equivalent in 2010 but the $11,040 equivalent of 2005 dollars in 2010. Discounting this by 5% you get $8,650. Now I'm not sure how you'd report the yield on this. Of course if you look at it as just buying $10,000 in future money ignoring inflation effects you'd say the yield is 3% on the 2000 bonds while the yield is 5% on the 2005 bonds
However if at the time of purchase (of the 2005 TIPS) expectations were for a deflation rate of 2% or greater for the next 5 years then the price of the 2000 bonds would be the same as the 2005 ones cause all you're buying here when you buy either the TIPS from 2000 or the TIPS from 2005 is $10,000 in 2010 money because IIRC TIPS don't adjust for deflation.
So I think Scott is right.
I'm going to say Scott is right. Think of it simply:
A particular bond pays the principal amount, adjusted for inflation (or deflation) in one year, and pays a certain amount of interest as well. Using standard present value accounting, we'd get something like this (ignoring discounting):
Current Price = Interest + (1 + expected inflation) * Principal
Naturally, if expected inflation drops, the current price will fall - but the interest payment won't. So, yields increase.
A particular bond pays the principal amount, adjusted for inflation (or deflation) in one year, and pays a certain amount of interest as well. Using standard present value accounting, we'd get something like this (ignoring discounting):
Current Price = Interest + (1 + expected inflation) * Principal
Naturally, if expected inflation drops, the current price will fall - but the interest payment won't. So, yields increase.
Lucas,
Actually I was doing simulations in Excel and I realized I don't know what it means when they report the yield on a bond.
You seem to be saying it's the next interest payment (times 2?) divided by the current market price of the bond? Do I have that right, and if so, are you confident of that?
The reason I ask is that with normal Treasurys, you can compute anything you want (current yield, yield-to-maturity, etc.) because the cash flows are set in stone, assuming no default.
But with TIPS, you don't know what the principal of the bond will be in the future, so you don't know how much you'll get back when the thing matures. So it wouldn't be an objective fact to report the yield-to-maturity, for example.
Once I realized that, I started to think maybe Scott is right. Because if you're just going off the things that are objectively locked in, then I could see how changes in expectations could cause the reported yield to swing.
The really tricky thing is that even the coupon payments aren't fixed for a TIPS, because they're the contractual interest rate (cut in half) times the principal, where the principal itself is adjusted based on CPI.
Actually I was doing simulations in Excel and I realized I don't know what it means when they report the yield on a bond.
You seem to be saying it's the next interest payment (times 2?) divided by the current market price of the bond? Do I have that right, and if so, are you confident of that?
The reason I ask is that with normal Treasurys, you can compute anything you want (current yield, yield-to-maturity, etc.) because the cash flows are set in stone, assuming no default.
But with TIPS, you don't know what the principal of the bond will be in the future, so you don't know how much you'll get back when the thing matures. So it wouldn't be an objective fact to report the yield-to-maturity, for example.
Once I realized that, I started to think maybe Scott is right. Because if you're just going off the things that are objectively locked in, then I could see how changes in expectations could cause the reported yield to swing.
The really tricky thing is that even the coupon payments aren't fixed for a TIPS, because they're the contractual interest rate (cut in half) times the principal, where the principal itself is adjusted based on CPI.
You're right, that is what I had in mind. I hadn't thought about the fact that interest payments change as you get inflation. Now that you bring it up, I'm not confident in what I said before.
So, I dug up this: http://www.treasurydirect.gov/RI/OFNtebnd to test the formula that the Treasury is using.
It's obvious that what the Treasury calls "yield" is not what I called yield. Rather, it seems to be yield-to-maturity for the non-TIPS bonds. For TIPS, I have no idea what calculation they're using, as the yield they report is far below standard YTM (assuming inflation = 0%) or the yield definition that I used. For the most recent TIPS auction, I could get the reported Yield and Price to reconcile if I assumed an expected inflation rate of about 0.5% - where that expected inflation rate came from, I don't know.
Looking at your graph from FRED, it's pretty obvious that the calculation I used in my statement before isn't what FRED is using... Interest Payments don't go negative or even to zero - but this yield does.
The big question - to which I can't find an answer - is how they calculate the yield on TIPS. Assuming that it's based on some relatively fixed objective criteria, then Scott should be right. But, I don't think that we have enough evidence to suggest that this is true...
So, I dug up this: http://www.treasurydirect.gov/RI/OFNtebnd to test the formula that the Treasury is using.
It's obvious that what the Treasury calls "yield" is not what I called yield. Rather, it seems to be yield-to-maturity for the non-TIPS bonds. For TIPS, I have no idea what calculation they're using, as the yield they report is far below standard YTM (assuming inflation = 0%) or the yield definition that I used. For the most recent TIPS auction, I could get the reported Yield and Price to reconcile if I assumed an expected inflation rate of about 0.5% - where that expected inflation rate came from, I don't know.
Looking at your graph from FRED, it's pretty obvious that the calculation I used in my statement before isn't what FRED is using... Interest Payments don't go negative or even to zero - but this yield does.
The big question - to which I can't find an answer - is how they calculate the yield on TIPS. Assuming that it's based on some relatively fixed objective criteria, then Scott should be right. But, I don't think that we have enough evidence to suggest that this is true...
I don't think the "massive spike in TIPS yields" ever happened. The yield the you're quoting quoting was stale the minute it was printed because of the lag between CPI computation and the bond market adjusting TIPS principal amount. The way oil was crashing in Fall 2008 told everyone that subsequent TIPS principal adjustments were going to be sharply down. You would have noticed much lower yields on new issue TIPS which are protected from deflation due to a quirk which makes the minimum maturity value equal to the principal value at issue. Old, inflated TIPS had more downside coming. Lately, time to maturity is less important than time from issue for this reason.
There was brief moment when TIPS were a screaming buy, owing to hyperinflation fears, but that was a flash in the pan. The second flash in the pan was commodities/oil bottoming out in Spring 09. Obvious future CPI increases are buy signal that will momentarily drop the yield as investors buy the upward principal adjustment.
Just my thoughts. With TIPS, the mechanics mean everything. BTW there is no 5 million cap if you're an institution or fund. How else would TIPS mutual funds or ETFs exist? This space is dominated by big players.
There was brief moment when TIPS were a screaming buy, owing to hyperinflation fears, but that was a flash in the pan. The second flash in the pan was commodities/oil bottoming out in Spring 09. Obvious future CPI increases are buy signal that will momentarily drop the yield as investors buy the upward principal adjustment.
Just my thoughts. With TIPS, the mechanics mean everything. BTW there is no 5 million cap if you're an institution or fund. How else would TIPS mutual funds or ETFs exist? This space is dominated by big players.
# posted by : November 16, 2009 1:29 PM
: November 16, 2009 1:29 PM
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