TIPS . . .

of the Iceberg

Inflation Protection

- the hidden risk of inflation protection

The large chunk of market risk from rising interest rates lying just below the surface of Treasury Inflation Protected Securities (TIPS) is one of the most widely overlooked concepts in the fixed income markets. The recent move up in interest rates and the corresponding large negative returns posted in most bond sectors, particularly TIPS, have sent investors in numerous directions looking for answers. From our travels over the past year meeting with clients and consultants to discuss our Protection Against Rates Rising (PARR) ideas, we have consistently experienced two strategies taking place: a shortening of duration (our recommendation) and an increased allocation to the TIPS sector (not high on our list). We have also encountered many prominent bond investors extolling the value of the TIPS market in shielding portfolios from the inevitable risk of high inflation brought about by the most accommodative Federal Reserve in history. In a sense, they are correct because in an environment of rising inflation TIPS are likely to outperform. But, outperform what? Yes, they may outperform similar maturity Treasuries, but what benefit is that to a portfolio if the return is still negative? The likelihood of TIPS posting negative returns is not discussed in commentaries, which makes us wonder how well the often downside risks of TIPS are truly understood. Rising Rates

September 2013
Ambassador Capital Management, LLC Detroit, Michigan Greg Prost, CFA Chief Investment Officer Tal Gunn Senior Portfolio Manager Mike Krushena, CFA Senior Portfolio Manager Derek Oglesby, CFA Quantitative Research Mike Vandenbossche, CFA Senior Portfolio Manager

In this piece we intend to illustrate that if inflation rates do rise in the bond investors have much better options than investing in TIPS. future, The simple reason is that TIPS are bonds with coupons and maturities and therefore are negatively affected by rising interest rates, which will certainly occur if inflation rises. TIPS, as their name implies, do receive additional compensation for changes in the level of inflation, which will counteract some of this rise in interest rates; however, the rise in inflation expectations will likely be much less than the rise in rates, offering limited protection. Following a brief discussion on the next two pages concerning the basic mechanics of the TIPS market we will demonstrate that, despite their name, TIPS do not offer much portfolio protection at all. In fact, they perform very poorly in both expanding and contracting economic environments.

September 2013

A SHORT PRIMER ON THE TIPS MARKET

1. TIPS have the same three main components that Treasuries have: a maturity date, coupon (income), and a principal payment at maturity. TIPS also have an additional fourth component that adjusts the principal value in line with the level of inflation (using CPI) a sort-of cost-of-living adjustment for the bond. 2. The stated yield on TIPS is less than similar maturity Treasuries by approximately the amount of expected future inflation. When interest rates rise (fall), the price of TIPS falls (rises) due 3. to its duration, similar to a typical Treasury security. If inflation expectations also rise with interest rates, some of the 4. decline in price in TIPS will be negated, but not all. The effect is similar to lowering the duration of the bond. Thinking about TIPS in terms of duration is helpful in understanding the level of inflation protection TIPS provide. 5. Higher inflation expectations will raise TIPS prices, and vice versa.

TIP(s) #1
TIPS have a shorter duration than similar maturity Treasuries when interest rates rise quickly.

duration is a measure of how sensitive a bond is to changes in Bond interest rates the higher the duration, the higher the sensitivity. As mentioned previously, many clients have shortened the duration of their portfolios to lessen the impact of higher future rates. An allocation to does the same thing, in essence. In our previous piece entitled TIPS How to Provide Protection from the Large Downside Risk in Bonds, we used a duration timeline to show the interest rate exposures for various fixed income approaches. We do the same thing below using TIPS:
*PARR is an acronym for Protection Against Rising Rates and refers to Ambassadors recommendation of using negative duration as part of a standard fixed income asset allocation to provide positive returns during periods of rising interest rates. Ambassador estimates that the duration of TIPS will be approximately 80% of the duration of a similar maturity Treasury in an environment of rising inflation and interest rates. That is, TIPS will participate in 80% of the price declines from higher rates. If interest rates were to fall instead due to a recession, the timeline would look different. In that environment, the implied inflation rate declines can be very steep, causing both the duration and returns for TIPS to be negative; and, sometimes very negative. For example, at the depths of the Great Recession during the second half of 2008, the Barclays 1-10 year TIPS Index returned -7.90% versus +8.76% for the Barclays Intermediate Treasury Index a difference of over 16%!

TIP(s) #2
TIPS also have a much shorter (and sometimes negative) duration than similar maturity Treasuries when interest rates fall due to an economic downturn, which is not a desirable attribute.

September 2013

WHY HAVE TIPS UNDERPERFORMED LATELY?

The intermediate TIPS market has lost the equivalent of five times its annual yield in recent months as interest rates have risen, providing a real world example of their inherent risks. During the months of May and June, yield levels on intermediate Treasuries reacted to Federal Reserve comments regarding the tapering of Quantitative Easing (QE) and rose almost 0.50%, which resulted in a return of -1.87% for the Barclays Intermediate Treasury index versus a return of -5.54% for the Barclays 1 TIPS index. Similar to Treasuries, TIPS lost approximately 2% 10 year based on the rise in interest rates; but, TIPS also lost an additional 3+% implied inflation rate on the securities declined. The implied as the (expected) inflation rate is calculated by comparing TIPS yields to similar maturity Treasury yields. The difference is what investors are willing to accept for the promise of receiving future inflation adjustments to their principal. In other words, TIPS should yield less than Treasuries by the approximate amount that investors expect future inflation to be. During May and June, the actual inflation rate itself barely moved, but the expectation of future inflation fell as the market interpreted higher rates to mean slower future growth and therefore lower future inflation.

TIP(s) #3
The change in investor expectations for future inflation drives the performance difference between TIPS and Treasuries; both good and bad.

4.0%

Implied Inflation Rate on 5-Year TIPS

3.0%

2.0%

1.0%

Recession

The move lower in implied inflation in May and June was not historically very large and remains well within historical bands.

0.0% -1.0% Jun-99

Jun-01

Jun-03

Jun-05

Jun-07

Jun-09

Jun-11

Jun-13

Source: Bloomberg, Ambassador

Understanding the implied inflation rate is key to understanding TIPS. As shown in the graph above, the implied inflation rate has remained in a tight range of 1.5 2.5% since TIPS were first issued 16 years ago. The two distinct time periods outside of that range occurred during the past two recessions. Any move downward in the implied ratio detracts from performance. Furthering our example from above, back on April 30th an investor in 5-year TIPS paid a price that assumed an additional return of from inflation over the life of the bond which is at the top of the 2.50% historical range. Two months later investors feared that the higher interest rates resulting from the belief the Fed would soon begin tapering would lead to a slower economy and lower inflation. At least that is how we interpret it, because the implied future inflation rate on 5-year TIPS dropped to 1.75%. That move combined with the rise in interest rates is what translated into the underperformance versus comparable Treasuries of 3.67%.

September 2013

HOW HAVE TIPS PERFORMED AS RATES HAVE FALLEN?

The Federal Reserve began lowering short-term interest rates in November of 2007, and since then intermediate TIPS and Treasuries have generated very similar annualized performance (4.10% vs. 3.94%). Individual year performance is quite different from one another, however, and again offers an opportunity to explain how TIPS work. The first chart below shows the same implied inflation rate (orange line) as the previous page, but shortens the time period to the beginning of the Fed rate cuts. The green line is the yield of the 5-year Treasury. We have separated the graph into five different time periods that exhibit five different market movements. The second chart graphs the returns for intermediate TIPS and Treasuries over the same five time periods using Barclays Index data.
4.0%
Implied Inflation

3.0%
2.0%

1.0%
5-yr Treasury

Since the end of 2007, or the start of the Great Recession, interest rates on 5-year Treasuries have steadily fallen (3.50% to 1.50%), while the implied inflation rate is relatively unchanged.

0.0%

-1.0%

1
Dec-08

2
Dec-09

3
Dec-10 Dec-11

4
Dec-12

Dec-07

Source: Bloomberg, Ambassador

TIP(s) #4
TIPS will not protect the portfolio during recessionary periods and can greatly underperform Treasuries.

The reasons for the TIPS index performance for each time period: 1) The implied inflation rate fell much faster than Treasury rates (-) 2) The implied inflation rate rose much faster than Treasury rates (+) 3) The implied inflation rate unchanged, while Treasury rates fell (=) 4) The implied inflation rate unchanged, while Treasury rates fell (=) 5) The implied inflation rate fell and Treasury rates rose (-) (-)

September 2013

WHY DO WE THINK TIPS REMAIN EXPENSIVE?

The following two graphs summarize the data from the previous page to how much the yield on the 5-year Treasury has fallen relative to the show implied inflation rate on TIPS, which has benefited TIPS returns. The first graph separates the same five time periods as earlier, but subtracts the implied 5-year TIPS inflation rate from the 5-year Treasury yield. The combination gives us the real TIPS yield. TIPS generally perform best if real yields are falling, which is exemplified by the fact that TIPS outperformed Treasuries in time periods 2-4 and underperformed in 1 and 5.

Despite the recent movement, real yields remain negative.

A natural progression to a positive real yield as the Fed removes liquidity will mean that would require interest rates to rise faster than the rate of inflation. Over the long-term the real rate on 5-year Treasuries has averaged over 2%, although the real TIPS yield has fallen steadily since inception (graph below). For TIPS real yields to get back to the 2% level interest rates would have to increase at least 2% more than the rise in the expected inflation rate. An example would be if the 5year Treasury moved to a yield of 5% (currently 1.65%), while the implied inflation rate on TIPS moved to 2.50% (currently 1.75%).
4.0%

Historical 5-Year TIPS Real Yield

TIP(s) #5
Negative real yields are not the historical norm and are not likely to continue as the Fed removes liquidity.

??
2.0%

0.0%

-2.0% Dec-98
Dec-00 Dec-02 Dec-04 Dec-06 Dec-08 Dec-10 Dec-12

Source: Bloomberg, Ambassador

September 2013

SCENARIO ANALYSIS
As we have shown in past articles, we believe that the best way to compare the inflation protection of various fixed income products is to run what-if scenario analysis. The scenario analysis presented below is prepared by Ambassador using three different assumptions for the economy over the next year: 1) a recession that lowers the 5-year Treasury yield to 0.25% and the implied inflation rate to 0%; 2) an unchanged environment; 3) economic growth that raised the 5-year Treasury yield to 5% and the implied inflation rate to 2.50%. The calculations assume that the event and subsequent change in yield levels happen at the end of year one, and the graph compares a 5-year TIPS index relative to both cash and a 5-year Treasury index. Please see the disclosures on page 8 for additional information on our assumptions.

Looking at these scenario results it is clear to us that investors should question the level of protection TIPS provide to portfolios at current interest rate levels and inflation expectations. The lack of downside protection during the next recession alone should concern most fixed income investors that are relying on TIPS for portfolio protection. But, it is the large negative return we estimate if the economy starts to take off that will be the most distressing to investors who are expecting protection from both higher inflation and interest rates. Even if we ran the scenario out five years TIPS would still underperform cash!

TIP(s) #6
TIPS perform poorly in both strong economic recoveries and downturns. TIPS yields are not enough compensation for this risk.

The only scenario we ran in which TIPS did not produce a negative return while interest rates are rising is during a period of stagflation, in which the economy is not growing, but inflation is rising quickly. It is historically rare for this type of situation to last very long, but it certainly is a possibility. We just find it unlikely that the Federal Reserve would wait very long to raise interest rates to combat such a situation.

September 2013

CONCLUSION

If you want to protect your bond portfolio from the risk of higher inflation, you would be better off concentrating on protecting it from higher interest rates. Inflation protection is definitely a worthy cause for fixed income portfolios because inflation erodes future asset values; but rising inflation also means higher interest rates, which erode current bond values and greatly lessen the benefit of inflation protected securities. Protection to us means not losing money, and there are too many realistic scenarios in that is the case for the TIPS market. which

Furthermore, the TIPS market is very expensive on a historical basis. With current intermediate Treasury yield levels below the level of inflation because of the Federal Reserve, there is a strong probability that these negative real yields will be reversed as the Fed becomes less accommodative. Using the analogy from the introduction The TIPS of the iceberg of inflation protection have melted away over time as real rates have fallen, while the much larger interest rate risks below the surface have increased as interest rates have hit bottom. We think it is time to get out of the water into something that offers better protection from both. Ambassador offers a solution called PARR (Protection Against Rising Rates) that uses the concept of negative duration to produce positive returns as the economy recovers. As with any investment vehicle there are risks, but our approach accomplishes the true goal of portfolio protection as interest rates rise that we believe many investors are seeking. Please contact us if you would like to discuss PARR as an option for your portfolios.

TIP(s) #7
Do not buy TIPS.

September 2013

Ambassador Capital Management strongly believes that a completely different approach to fixed income investing is warranted in the current, low yield environment. This includes not only maturity decisions, but also implications for credit risk exposure as well. After digesting this report, if you come to the same conclusion, we would welcome a discussion on ideas we have on how to best position fixed income portfolios going forward.

For further information, contact:

Mike Vandenbossche, CFA Ambassador Capital Management

IMPORTANT DISCLOSURES Results presented in this analysis indicate market scenarios that have inherent limitations and in no way should be considered representative of the past performance of any actual investment product or predictive of future investment expectations for the benchmarks. The results for individual portfolios may vary depending on actual market conditions and the composition of the portfolio. The scenarios assume that bonds are purchased at current valuations and held throughout the period rather than traded, which would not be the case in an actual portfolio. The scenarios also rely on mathematical models that do not take into account all potential factors that could impact return, including maturity roll and twists, and can be wrong even in cases where the assumptions used turn out to be valid. Actual market events or results could be yield curve much worse. The analysis also does not show the impact of any management fees or other expenses, which would reduce cash flows. This paper is provided for informational purposes only and should not be construed as investment advice. The statements contained herein reflect the subjective judgment and assumption of the author and the opinions of Ambassador Capital Management, LLC. and the information at the time of publication. Investment recommendations may be inconsistent with these opinions. There can be no assurance that available developments will transpire as forecasted and actual results will be different. Hypothetical examples are shown for illustrative and educational purposes only. Data and analysis does not represent the actual or expected future performance of any investment product. We believe the information, including that obtained from outside sources, to be correct, but we cannot guarantee its accuracy. The information is subject to change at any time without notice.

Director of Marketing & Client Servicing mvandenbossche@ambassadorcapital.com 313-961-3111

500 Griswold Street, Suite 2800 Detroit, Michigan 48226

Assumptions for Scenario Analysis calculations: - The analysis assumes the changes take place on the last day of the year start date: 8/31/13. - The calculations use an index approach and therefore the securities do not age over time. - The recession scenario assumes the 5-year Treasury yield falls from 1.65% to 0.25%, and the 5-year TIPS implied rate of inflation falls from 1.75% to 0.0%. - The growth scenario assumes the 5-year Treasury yield rises from 1.65% to 5.0%, and the 5-year TIPS implied rate of inflation rises from 1.75% to 2.50%.