Inflation is an equal opportunity risk, harassing everyone regardless of race, creed, color or portfolio size. Yes, the threat can be neutralized to a degree with Treasury Inflation-Protected Securities, or TIPS. But it's an imperfect defense. TIPS may be many things, but tax-friendly isn't one of them.
Choosing between inflation and taxes is not much of a choice, particularly for wealthy investors who typically have a fair share of assets subject to Uncle Sam's bite. Fortunately, there's more than one way to fight inflation in taxable accounts, as explained by Ben Thompson, a portfolio manager and one of 11 founding principals of Samson Capital Advisors, a boutique fixed-income shop in New York with more than $3 billion under management.
In May 2006, Thompson's firm began offering its tax-efficient inflation-protection strategy to clients--primarily high-net-worth individuals, some of whom come to Samson via wealth managers. The firm's strategy marries municipal bonds (and their tax-free coupons) with a swap, otherwise known as over-the-counter derivatives. The swap here is of the zero-coupon variety, and its value is linked to the consumer price index (CPI), a widely used measure of U.S. inflation and the underlying benchmark for calculating TIPS coupon payments.
The firm's inflation-protected, tax-efficient strategy is available through a limited partnership that currently holds nearly $100 million. The minimum investment is $250,000. Its main selling point: The strategy strives to lock in a higher inflation-adjusted, after-tax yield, compared to the after-tax payout of TIPS in taxable accounts.
Samson's strategy is innovative, but it's not completely free of competition. For example, the JP Morgan Tax Aware Real Return Fund offers a similar product in a mutual fund. In fact, Thompson was a managing director and head of Tax Aware Fixed Income Investments at JP Morgan Fleming's U.S. fixed income group before leaving to help launch Samson in 2004. A distinguishing characteristic of Samson's strategy is that it's levered to inflation. As a result, returns will beat TIPS if inflation is higher than expected, or lag TIPS if inflation is tamer than the market predicts.
What's the rationale for your tax-efficient inflation-protection strategy?
It's difficult for tax-paying investors to find an inflation-protection strategy that's efficient after taxes. TIPS income and inflation accretion are fully taxable to U.S. taxpayers. Unfortunately, taxes are quite a significant drag on TIPS returns.
What are the typical tax rates for your high-net-worth clients?
Typical rates are 28 percent or 35 percent. The 35 percent rate is the full marginal rate, and 28 percent is the alternative minimum tax (AMT) rate. A lot of high-net-worth investors are in the 28 percent AMT rate.
Given those rates, how would a TIPS investment fare in a taxable account?
TIPS trade on a real, or inflation-adjusted yield basis. The real yield subtracted from the nominal yield on a standard Treasury of the comparable maturity is the break-even inflation rate. If inflation runs above the break-even rate, then TIPS would be a better investment [than the comparable nominal Treasury] because the inflation-related return would be larger than expected.
At the moment [February 8, 2007], the 10-year nominal Treasury is at about 4.75 percent. The current real yield on the 10-year TIPS is about 2.40 percent. So the break-even rate is 2.35 percent (4.75 minus 2.40). If inflation runs above 2.35 percent, you'd be better off in TIPS. If inflation's below 2.35 percent, you'd be worse off in TIPS.
Let's say that inflation comes in right at market expectations, or 2.35 percent, as priced by the TIPS market at the moment. The real yield today with TIPS is 2.40 percent. So, with inflation plus the real yield, you'll receive 4.75 percent [2.35 plus 2.40]. To figure what a 35-percent taxpayer keeps, multiply that yield by 0.65. The 4.75 percent nominal yield falls to roughly 3.10 percent after taxes.
Assume that the 3.10 percent is what you keep after tax. But you still have to subtract the inflation of 2.35 percent from that nominal yield. As a result, the real yield after taxes for investors in the 35 percent tax bracket drops to 75 basis points. For investors at the 28 percent rate, the real after-tax yield on the 10-year TIPS is 1.05 percent.
Keep in mind, too, that with TIPS you're not only taxed on the real yield, but on the inflation, too. The higher inflation goes, the greater the tax on the inflation component.
So, TIPS are tax inefficient. What's the alternative?
Before I talk about our approach, I should note that there are publicly available securities in the municipal bond market that are inflation-linked and pay tax-free coupons. Unfortunately, the improvement in real yield [over TIPS] isn't significant.
Overall, inflation-linked muni debt is still a small sector relative to the entire muni bond market. One reason is that all of the muni CPI bonds are hedged in some way back to the TIPS market. No muni issuer has actually taken inflation risk directly.
How does a CPI swap work?
It's an instrument for trading the break-even inflation rate in TIPS. Here's how it works: I enter into a trade with Barclays, Lehman Brothers, BNP Paribas--counterparties that we use--and I contract to pay the prevailing fixed rate. In return, they'll pay me the inflation rate.
So, you're paying a fixed rate for a CPI swap, determined by market prices at the time of the trade. In return, the counterparty pays you a variable rate, depending on inflation. If inflation rises, you'll be paid more. If inflation falls, you'll be paid less.
Exactly. I'm taking the same position as the TIPS investor. Today, I'm locking in an inflation rate of 2.65 percent--that's what I'm paying out. If inflation goes above 2.65 percent in the future, I'll be paid more than I pay out. If inflation goes below 2.65 percent, I'll pay more than I get.
Okay, now let's talk about your firm's tax-efficient inflation-hedged strategy.
We pair a municipal bond with a CPI swap to create a tax-efficient inflation-linked return. Clients receive tax-free muni bond income along with an instrument that's adjusting its payout with inflation.
What maturity are you using for the munis?
It's a little further out than 10 years. The reason is that the muni bond curve is typically steeper than the taxable curve. As you go out further in maturity and duration in munis, you get a greater improvement in income than you do in taxable markets.
Meanwhile, the break-even inflation-rate curve is almost perfectly flat. If I buy a 10-year TIPS or a 30-year TIPS, the break-even inflation rate is just about the same. So if I buy a longer muni bond with a higher yield, I can execute a longer CPI swap but pay no more for the swap than if I paid for a shorter CPI swap. As a result, I'm increasing the real yield that's being earned on the muni.
How does the strategy look with actual numbers from the markets?
If I buy a 10-year muni bond today, I could probably buy at a 3.9 percent yield. I can also buy a CPI swap at 2.65 percent, which includes a bit of a spread over the actual break-even rate. So, 3.9 percent less 2.65 percent is a 1.25 percent real yield.
If I execute those two pieces, I'm going to earn a coupon stream of 3.9 percent tax free. Meanwhile, I've got a comparable-term CPI swap that pays if inflation rises above 2.65 percent. But I'll pay if inflation falls below 2.65 percent. In other words, I've effectively locked in a real yield of 1.25 percent.
That's an after-tax real yield of 1.25 percent versus your earlier quote of TIPS' after-tax real yields of 0.75 percent to 1.05 percent, depending on the tax bracket.
Right. If you move a little further out on the muni bond curve, you can improve the 1.25 percent real yield dramatically.
Assuming you have a gain in the CPI swap, as you would if inflation rises higher than expectations, how is the gain taxed?
It's not perfectly tax-efficient. The degree of tax efficiency comes from the long-term capital gain that would be realized on the CPI swap. But because it's a zero-coupon instrument, there's no current income--neither side of the swap pays anything before maturity. We use zero-coupon instruments because we want a pure inflation linkage. We favor the 15-year part of the yield curve on the CPI swap. We also purchase options on CPI swaps, which are floors that are similar to put options that protect against significant declines in value.
So you won't pay capital gains, if any, on the CPI swap until it matures in 15 years?
Correct, because it's a zero-coupon. You pay 15 percent on the amount above the expected inflation rate in a CPI swap. In contrast, with TIPS, you're taxed on all of it at the higher ordinary income rate of 28 percent or 35 percent, depending. Also, with a CPI payment, your tax payment is deferred.
What else differentiates your strategy from a straight TIPS investment?
The level of exposure to inflation in our strategy is amplified relative to the bond exposure. For every bond, we have four CPI swaps. By comparison, a one-to-one application--one muni bond and one CPI swap--has a return and volatility profile similar to TIPS. If you increase the inflation exposure, you become more and more of a pure inflation-linked instrument and less of a TIPS-like instrument.
Finally, how does your strategy fit into a larger investment portfolio?
If you allocated 10 percent of assets to TIPS, the portfolio is effectively protecting 10 percent of assets from inflation. Meanwhile, someone may invest 3 percent to 5 percent of the portfolio in our strategy, and that 3 to 5 percent carries an amplified exposure to inflation, so it could conceivably cover 20 percent to 30 percent of a portfolio, or more. So you put up less capital, but the inflation exposure is amplified.
James Picerno (firstname.lastname@example.org) is senior writer at Wealth Manager.