TIPS Prove Poor Tip for Traders Betting on Inflation

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July 30 (Bloomberg) -- Treasury investors say inflation is abating, even if the oil bulls are right and crude heads to $100 a barrel.

Pacific Investment Management Co. and Fidelity Investments sold Treasury inflation-protected securities maturing next year, confident that consumer prices will remain in check. Money managers lost as much as $275 million on so-called TIPS in the second half of 2006 because oil fell from record highs and gasoline prices dropped.

Yields on TIPS due in January are lower than those on similar-maturity Treasuries by about half a percentage point, a gap that represents the rate of inflation investors expect over the life of the notes. The difference was about 2 percentage points a year ago for six-month securities.

``The TIPS market is saying right now there is no inflation risk the next six to twelve months,'' said John Brynjolfsson, who oversees $50 billion of inflation-protected assets at Newport Beach, California-based Pimco, a unit of Munich-based insurer Allianz SE.

Brynjolfsson, whose $11.5 billion Pimco Real Return Fund is the largest for inflation-protected bonds, held $1.1 billion of TIPS maturing in January 2008 at the end of September and sold $702 million of them within six months, according to data compiled by Bloomberg.

A $1.3 billion fund managed by Boston-based Fidelity, the world's biggest mutual-fund company, sold all its $60 million of the security in the six months through April 30. Spokeswoman Deborah Pont said Fidelity doesn't comment on trading.

Inflation Links

TIPS, created by the Treasury in 1997 to compete with the U.K., Australia and Canada in selling inflation protection to pension funds, lagged behind Treasuries the last two years as the Federal Reserve kept inflation in check. They returned 2.7 percent in 2005 and 0.5 percent last year, versus 3.7 percent and 2.4 percent for comparable-maturity Treasuries, according to Barclays Capital Inc. in New York, which says it's the largest dealer of the securities.

TIPS underperformed Treasuries last week. The benchmark 10- year note's yield plunged 19 basis points to a two-month low of 4.76 percent as investors dumped riskier assets. The comparable TIPS yield declined 15 basis points to 2.45 percent.

Inflation-protected notes pay interest at lower rates than Treasuries on a principal amount that's linked to the Labor Department's consumer price index. The CPI rose 2.5 percent last year and 3.4 percent in 2005. It hasn't exceeded that rate since prices rose 6.1 percent in 1990.

`Off a Cliff'

Short-maturity TIPS ``performed disastrously'' last year as inflation ``fell off a cliff'' during the second half, Brynjolfsson said. The inflation rate used to calculate interest payments on TIPS slowed to 1.3 percent in October from 4.3 percent in June.

Investors got burned because they anticipated that storms would disrupt energy supplies and push gasoline prices higher like a year earlier when Hurricane Katrina struck the U.S. Gulf Coast, said Michael Pond, an inflation-linked debt strategist at Barclays in New York.

Instead, crude oil futures tumbled to $60 a barrel in October from a record $78.40 in July. The retail price of gasoline, accounting for 4.1 percent of the CPI and its most volatile energy component, fell to $2.20 a gallon from $3.04, according to the American Automobile Association.

``For short-term TIPS in particular, what matters more than oil is gasoline,'' Pond said.

$100-a-Barrel

Traders financing holdings of the security that matured in January 2007 at the Fed's 5.25 percent target rate for overnight lending between banks lost 1.4 percent from mid-July through maturity. That amounts to about $275 million, based on the initial face value of $20 billion of TIPS, according to Frankfurt-based Deutsche Bank AG.

Oil futures rose to $77.02 a barrel last week, 1 cent short of a record close. Analysts at New York-based Goldman, Sachs Group Inc. say crude is likely to reach $95 this year, while CIBC World Markets in Toronto forecasts $100 as soon as next year.

At the same time, gasoline is falling. The average pump price of $2.92 a gallon for regular unleaded was down 9.6 percent from its May 23 peak of $3.23.

Swings in gasoline prices have the greatest effect on the prices of TIPS that mature soon because of their potential to boost or cut the few payments left on the bonds.

The average daily yield change this year for TIPS maturing in January is 6.2 basis points, compared with 2.8 basis points for 10-year TIPS. Ten-year TIPS yield 2.37 percentage points less than regular Treasuries, in line with their average over the past year. A basis point is 0.01 percentage point.

Avoid Volatility

``They are so highly correlated with gasoline prices, and gasoline prices are just so highly volatile that we avoided those securities altogether,'' said James Evans, who oversees $4 billion of inflation-linked bonds at Brown Brothers Harriman & Co. in New York. He hasn't held the January 2008 TIPS for more than a year.

Bond market indexes including the ones compiled by Barclays and New York-based Lehman Brothers Holdings Inc. remove securities that come due in less than 12 months, giving money managers another incentive to drop them, Evans said.

Dealer holdings of TIPS surged to the highest in at least nine years during the second quarter, according to the Fed Bank of New York, which gathers data from the 21 banks that underwrite Treasury auctions.

Holdings of TIPS by the dealers climbed to $8.14 billion during the week of April 25. From 1998 through the end of last year, primary dealer TIPS holdings averaged $1.7 billion a week.

Risk-Averse

The January 2008 note accounted for much of the increase in holdings, according to traders. Investors ``are a lot more risk- averse on this year'' when it comes to the shortest-maturity TIPS, said Gang Hu, head of inflation trading at Deutsche Bank in New York.

The difference between the amount of TIPS held in inventory and what's been sold to customers was $5.6 billion in the week ended July 18, the Fed said July 26.

In regular Treasuries, dealers normally are net short, meaning they've sold more securities than they have in inventory as a hedge against higher-yielding corporate, federal agency and mortgage-backed bonds. Last week net short positions in regular Treasuries totaled $194 billion, the biggest in nine years of data compiled by the Fed.

``This may be a situation where big risk-takers have gotten burned and like a cat on a hot stove are going to be cautious about biting off another chunk of risk,'' Brynjolfsson said.