I’m not a huge Fish ‘n’ Chips fan. But give me tips and tapes and I’m very happy! Growing up vegetarian in India, I came to the United States when I was 18. The only on-campus job I could get was flipping burgers at the Red Door Café at Caltech, where the cafe owner told me I had to “flip them, not eat them.” , the Red Door now offers “smoked tofu”, hummus, grain salad and other vegan dishes.

The hard work at the burger joint paid off and I was sort of promoted to server at the Caltech Athenaeum, where I had the pleasure of serving (and once spilling soup) the Richard Feynman, the Nobel Prize-winning physicist. Working in a student cafeteria gave me an “optionality”; that’s to say. Either way, I knew I was going to be able to at least survive on my own, and that resulted in “convexity” – that is, big gains from small but important decisions at the right time. moment. Lots of upside potential with limited downside.

Today I’d like to discuss a few items on the government bond menu that offer a similar type of asymmetric risk-reward:
S (Treasury Inflation Protected Securities) and STRIPS (Separate Trading of Registered Interest and Principal of Securities). At the time of this writing, they offer meaty yield and above all convexity in uncertain macro conditions. Under the specter of a “resolute” Fed that could end up busting financial markets to fix its massive mistakes in managing monetary policy and inflation, this choice provides plenty of protein for stock-heavy portfolios overloaded with carbohydrates.

FIRST TIPS: As I wrote a few weeks ago on this forum, TIPS pay an actual coupon rate, which is usually quite low (since actual yields are equal to nominal yields minus inflation), but the principal of these securities increases with inflation based on the CPI Inflation Rate. For TIPS ETFs like the iShares TIP, the increased principal is actually paid monthly. So if inflation is 8%, say 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 component inflation. Of course, if inflation fell to zero, there would be no inflation compensation. Thus, an ETF like TIP currently offers an “indicated yield” of more than 10%! (Source: Bloomberg) And this for a Treasury that has no credit risk. If inflation is a tax on the ordinary person, then for TIPS holders the payment is a kind of tax refund. TIPS are an inflation call option.

Next BANDS. STRIPS are essentially zero-coupon bonds that are the building blocks of regular treasury bills, stripped from their parent treasury bills for your consumption pleasure. Routinely, the Treasury issues bonds that have both a coupon and a principal. Due to demand from those who want bullet cash flow one day in the future (e.g. a lump sum payment against a one-time insurance obligation, or to pay a defeasance), the government allows dealers to withdraw principal and the middle coupons, slap a new label on them, and sell them as separate separate bonds. I have previously called this type of zero-coupon bond the “god particle of finance” because they are ultimately the lifeblood of all financial instrument prices.

Since principal strips belong to a specific bond, while coupon strips can come from many different bonds with the same coupon dates, there is a premium for principal (“P”) strips over coupon (“C”) strips in terms of a lower yield on the P strips. In the table below I show the 3% full coupon bond issued in 2014, along with its zero coupon strips at by way of example (Source: Bloomberg, as of August 26, 2022).

For our discussion, both types of bands can be treated the same. For example, if I were to buy a STRIP maturing in 2044, at the time of this writing, it would cost me about 45 cents on the dollar, and in 2044, on the maturity date, I would get back 1 dollar. The reason this is interesting is because of the convexity of the bands relative to the full bond with all the coupons. Note that the percentage price movement, or duration, of strips is more than 50% higher than that of full bonds. The volatility of interest rates means that long-term strips are more convex than coupon bonds of equivalent maturity, because the intermediate coupon payments do not weigh on the zero-coupon bond. In this example, if yields rise or fall by 100 basis points, the full bonds will lose 14.37 points, while the zero coupon bond will lose 9.7 points. Convexity increases with volatility. Thus, in a sense similar to options, strips offer a call option on the volatility of long-term interest rates.

So there we have it. TIPS are a call option on rising inflation, and STRIPS are a call option on rising volatility of returns. With inflation raging, the Fed pledging to fight it at all costs, and a lot of macroeconomic uncertainty, the ability to own call options against macroeconomic volatility can be had today in the bond markets with TIPS and STRIPS while receiving a good return at the same time. time. This is the equivalent of offering the two burgers and vegan dishes on the menu, something everyone can enjoy, lots of good protein for your wallet and healthy at the same time.

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