So, we have a question. Despite high inflation, why haven’t treasury inflation-protected securities or TIPS (Treasury Inflation-Protected Securities) funds gone through the roof? Is it because of the higher durations that TIPS loss outweighs TIPS and funds gains? If so, then why are short-term TIPS not skyrocketing up?
Yeah. Okay. So, first TIPS have two components. First, they have a real yield which then gets added to every month, whatever the CPI is. And that’s the rate of interest that gets added—that’s your return. But they also have duration and that means term risk. So just like there’s a difference between the performance of a one-year or five-year and a 30-year bond, if interest rates are going up, the 30-year bond will get hit the most and the five-year in between and the one-year, the least, and if rates are going down, then the long bond will benefit the most. What we’ve seen is a dramatic rise from exceptional historically record low levels of real interest rates. In fact, TIPS yields were sharply negative up until recently. And so that those that rise in the TIPS required real rate return has offset the benefits that you got from the inflation rate. So, you have to consider both of those. If you want a pure inflation edge, then shorter-term TIPS are better than longer-term TIPS, but then you give up the term premium with longer-term TIPS. Generally, you’re going to have a higher, real yield than shorter-term TIPS. So, that’s something you need to consider. We think that there are other good ways to address the inflation risk without taking that term risk.
We in fact use funds that are engaged in what’s called middle-market private lending. So, they lend to companies that can’t issue their own bonds. They’re not big enough. And the large banks have gotten out of that market after their great financial crisis and the need to restore their balance sheet. So private lenders and hedge funds have taken over that market. And we invest in funds run, for example, by Cliffwater, the fund is CCLFX. For those of you interested, it has no duration. It’s one month all floating rate, and it’s highly secured loans with average loan to value of less than 50% currently. And the historical default rates because of that senior secured debt backed by strong covenants and almost all loans are also backed by private equity. So, they’re less likely to walk away if there’s a default because their equity would get wiped out. The defaults in this space have been less than about 2% a year and recovery rates are 70%. So, the average loss over the cycle has been 60 basis points. And that includes through the great financial crisis and through the COVID crisis. Current yield is about 7.2%, I believe. So, you’re getting a massive premium over short-term interest rates, and you have no duration risk.
That’s one way to address the problem, but TIPS are the only pure inflation risk hedge without any credit risk, but you can have the duration risk if you’re buying longer-term ones.