Morgan Stanley is telling clients to pare Inflation Protection Securities because TIPS Flunk Inflation Test as Fuel, Food Overtake CPI.

Treasury Inflation Protected Securities aren’t living up to their name for bond investors who say they can’t trust the way the U.S. government calculates the rising cost of consumer goods.

Morgan Stanley, the second-biggest securities firm, and FTN Financial, a unit of Tennessee’s largest bank, are telling clients to pare holdings of TIPS, whose principal amount rises with the Labor Department’s consumer price index. Morgan Stanley says derivatives tied to inflation expectations are a better bet, while FTN recommends corporate and agency bonds because the index doesn’t reflect the actual rate of U.S. inflation.

The $500 billion TIPS market’s 5 percent returns this year have beat a 2.2 percent gain for Treasuries, according to Merrill Lynch & Co. indexes. TIPS should pay more, because the consumer price index downplays the 39 percent increase in gasoline and a 133 percent rise in corn in the past year, investors say. Yields on TIPS relative to Treasury debt, a gauge of traders’ inflation bets, barely changed over the past 18 months even as consumer expectations for prices climbed to 3.4 percent, the highest since 1995.

“The consumer price index underestimates inflation,” said Jeremy Wolfson, who oversees $8.5 billion as chief investment officer at the City of Los Angeles Department of Water and Power Pension Fund. “Whether TIPS are adding a true inflation hedge, that’s arguable based on the CPI component of it.”

My Comment: The CPI does not understate inflation because the CPI is not a measure of it. Yes, the CPI understates prices,primarily because housing prices are not properly reflected in the CPI.

TIPS “haven’t paid off” because the breakeven rate has “barely budged” over the past 18 months, said George Goncalves, chief Treasury and agency bond strategist with Morgan Stanley in New York.

My Comment: TIPS are up 5% this year, the S&P; is down 15% and The Lehman iShares Aggregate Bond Fund (AGG) is negative on the year. The PowerShares High Yield Corporate Bond Portfolio (PHB) is down 8%. I suggest TIPS have paid off quite nicely.

Investors should purchase derivatives that exploit concerns about inflation more efficiently than TIPS, Morgan Stanley advises. So-called swaptions allow investors to buy the right to purchase an inflation swap, in which one party agrees to pay a fixed rate in exchange for the inflation rate. Even if the CPI doesn’t immediately rise, the instrument gains value on expectations for future increases.

Point blank, my advice is to tell Morgan Stanley to go to hell. In the past few years investors have gotten crucified listening to advice from the brokerage houses peddling asset backed commercial paper, mortgage backed securities, interest rate derivatives, and other garbage at high commission rates. I feel the same way about swaptions right now. If swaptions are such a good deal, then why is Morgan Stanley so willing to take the other side of them?

PHB – Power Shares High Yield Corporate Bond Portfolio

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AGG – iShares Lehman Aggregate Bond Fund

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TIP – Lehman iShares TIPS Bond Fund

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Price inflation is a lagging phenomenon. Yet the whole world is misguidedly screaming “inflation” now over price concerns. Yes, there is “inflation”, but not in the US, at least as properly defined (an expansion of money supply and credit). There, is however, massive monetary printing in China, India, and Vietnam that is affecting commodity prices worldwide, making it seem as if inflation is the threat.

A proper focus is on credit conditions, not prices. With a virtual lockup on credit in the US and UK, there is huge negative pressure on treasury yields. And with default risk rising, there is huge upward pressure on corporate bond yields.

This is a very poor environment to switch from TIPS to corporate bonds as suggested by FTN. It is also a very poor environment for the swaption advice being peddled by Morgan Stanley.

Mike “Mish” Shedlock
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