I’m not a big fan of Fish ‘n’ Chips. But give me tips and strips and I’m very happy! Having grown up a vegetarian in India, I came to the United States when I was 18 years old. The only job on campus I could get was flipping burgers at the Red Door Café at Caltech, where the boss of the café told me “I had to flip them, not eat them.” Keeping with the times, Red Door now offers “smoked tofu ”, hummus, bean salad and other vegan menu items.
The hard work at the burger joint paid off, and I was promoted to waiter at the Caltech Athenaeum, where I had the pleasure of serving (and once spilling soup) Richard Feynman, the Nobel Prize-winning physicist. Working in a student cafeteria gave me “option”; namely. Whatever happens, I knew that I would at least be able to survive on my own, and this resulted in “convexity”, meaning big wins from small but important decisions at the right time. Lots of upside potential with limited downside.
I’d like to discuss a couple of items on today’s government bond menu that provide a similar type of asymmetric risk-reward: TIP TIP S (Treasury Inflation-Protected Securities) and STRIPS (Separate Trading of Recorded Interest and Principal). values). As of this writing, they offer a meaty yield and, above all, convexity in uncertain macroeconomic conditions. Under the specter of a “resolute” Fed that could end up busting financial markets to correct its massive mistakes in handling monetary policy and inflation, this pick provides plenty of protein for carb-overloaded portfolios (stocks). .
First TIPS: As I wrote a couple of weeks ago on this forum, TIPS pay a real coupon rate, which is usually quite low (since real yields are equal to nominal yields minus inflation), but the main of these Values increase with inflation based on the CPI inflation rate. For TIPS ETFs like the iShares TIP, the principal increase is paid each month. Thus, if inflation is 8%, for example, each month the increased principal, assuming nothing else changes, will result in a distribution to the registered TIPS holder of a coupon of 8%/12 of the inflation component. Of course, if inflation falls to zero, there would be no compensation for inflation. So an ETF like TIP currently offers an “indicated return” of over 10%! (Source: Bloomberg) And this is for a Treasury that has no credit risk. If inflation is a tax on the common person, then for TIPS holders, the payment is a kind of tax refund. TIPS are a call option on inflation.
Next STRIPS. STRIPS are basically zero coupon bonds that are the building blocks of regular Treasuries, stripped down to their original Treasuries for your consuming pleasure. As a matter of course, the Treasury issues bonds that have coupon and principal. Due to demand from those who want bullet cash flows at a day in the future (for example, a lump sum payment against a single insurance obligation, or to pay for an override), the government allows merchants to remove the main and intermediate coupons, slap a new tag on them and sell them as separate stripped bonuses. I have previously called these types of zero coupon bonds the “god particle of finance” because they are ultimately the cornerstone of all financial instrument prices.
Because principal tiers pertain to a specific bond, while coupon tiers can originate from many different bonds with the same coupon dates, there is a premium for principal (“P”) tiers over coupon (“C”) in terms of lower yields on P strips. In the table below, I show the full 3% coupon bond issued in 2014, along with its zero coupon strips as an example (Source: Bloomberg, to August 26, 2022).
Comparison of the “full” November 2044 Treasury bond and its stripped “coupon” and its “main” STRIP … [+]
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For our discussion, the two types of strips can be treated in the same way. For example, if I were to buy a STRIP expiring in 2044, at the time of this writing it would cost me approximately 45 cents on the dollar, and in 2044, at the expiration date, I would get back $1. The reason this is interesting is because of the convexity of the strips relative to the full bonus with all coupons. Please note that the percentage price movement, or duration, of strips is over 50% higher than full bonuses. The volatility of interest rates means that long-term strips are more convex than equivalent-maturity coupon bonds, because intermediate coupon payments do not weigh on the zero-coupon bond. In this example, if yields rise or fall by 100 bps, full bonds will lose 14.37 points, while zero coupon bonds will lose 9.7 points. The convexity increases with volatility. So, in a sense similar to options, strips provide a call option on long-term interest rate volatility.
So there we have it. TIPS are a call option on rising inflation, and STRIPS are a call option on rising yield volatility. With inflation on the rise, the Fed pledging to fight it at all costs, and a lot of macroeconomic uncertainty, the ability to hold call options against macroeconomic volatility can be had today in the bond markets with TIPS and STRIPS while receiving a good yield at Same time. weather. It is the equivalent of offering both burgers and vegan products on the menu, something that everyone can like, a lot of protein that is good for your wallet and healthy at the same time.
Source: www.forbes.com