TIPS selling for negative yield first time ever

First things first, TIPS are Treasury Inflation Protected Securities.  The purpose for the creation of TIPS is to protect investors from the negative effects of inflation.  TIPS are able to achieve this by having a fixed interest rate, usually very low (in the case of the most recent auction, just .5%), and adding an indexing factor based on the CPI (Consumer Price Index).  The indexing is accomplished through an adjustment to the principal value based on the CPI.  So, while the interest rate remains fixed, the semiannual coupon payment is adjusting for the effects of inflation by an increase in the principal amount.  For example, if a TIPS bond is issued at par for $1,000 at a 2% annual rate, and inflation is 1% over the first 6 months, the inflation-adjusted principal would be ($1,000 * 1.01) $1,010.  The investor would receive a coupon payment of ($1,010 * (2% / 2 payments per year)) $10.10.  This differs from the $10 the investor would have received without the inflation adjustment to the principal.  Inflation is constantly adding to the principal and that final amount is repaid at maturity along with the last coupon payment.

In the case of the most recent TIPS auction, investors purchased the TIPS with a rate of .5% at a premium, $105.50 for a $100 face value bond.  Over the life of these bonds, the .5% rate alone, without the inflation adjustment to the principal would result in the -.55% yield due of the premium over face value.  With very moderate inflation around 1.5% every year for the life of the bond, investors who purchased these TIPS would break even.  Inflation has historically averaged 3% since 1926 and 1.1% the last 12 months.  So, if inflation heads towards the 3% historical rate, past the 1.5% break even, these investors will be returning money on their investment, most likely at a better rate than the near zero money market rates.

After an extended period of the Fed keeping short-term interest rates bordering zero to spur the economy and wage war on deflation, it seems as though inflation is starting to be priced into the market.  This is with anticipation of more quantitative easing measures by the Fed to purchase securities in the open market with newly printed money.  If the old truth holds that bond investors are a step ahead of equity investors, prepare for inflation and quit worrying about deflation.

I hope that settles some requests about the understanding of this negative yield TIPS auction.  Please continue providing feedback and requests and always *preserve your capital*!

Frontier, Emerging Markets

One of the most profitable opportunities out there in my eyes right now is an investment in frontier or emerging markets.  Frontier markets are economies that have yet to develop into what are known as emerging markets.  Once they become emerging markets, their next step is to join the U.S. as a developed market.  You can probably deduce by now that the frontier market is riskier than the emerging market and so on.  As with any investment, these risks require greater return. But, I believe there is return in excess of the compensation for the risk borne. 

I believe that investors are still sleeping on these opportunities out of naivety and fear.  The International Monetary Fund expects emerging and frontier markets to grow at nearly 3 times the average rate of developed markets.  Goldman Sachs strategists predict that emerging market total market capitalization will skyrocket from $14 trillion to $80 trillion in the next 20 years.  They have outstanding consumer growth led by rapidly expanding middle and lower-middle classes.  Some argue that these higher growth rates combined with healthier demographics provide a safer investment than in developed economies.  What did we keep hearing about during the recession?  How this company and that company were cutting costs, becoming leaner, more efficient.  Did that not happen in less developed economies also?  I think it probably happened to a larger extent because they were more strapped for cash.  Now with more growth and even leaner companies, it sounds like a recipe for a risk-adjusted excess return on your investment.  

There are a number of fundamental risks with frontier and emerging market investments.  Inherent in every investment is economic risk, which is more exaggerated in less developed economies. You need to also be aware of sovereign and liquidity risk with these markets.  However, the nature of ETFs enables you to shed much of the liquidity risk through a higher volume of trading and the sovereign risk with diversification.  Here are some ETFs that track frontier markets: FRN, MES, AFK, PMNA.  And emerging markets: EEM, VWO.  Take a look at those and see which markets and sectors you want to get exposure to.  

Enjoy and always *preserve your capital*!