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(Bloomberg) — When the traders and investors who advise the U.S. Treasury floated the idea of selling bonds indexed to inflation in health care and education, they were drawing on work that Nobel laureate Robert Shiller began a generation ago.
It’s also work that Michael Ashton, a money manager who specializes in hedging specific inflation risk, latched onto more than a decade ago. That’s when he and Shiller tried — unsuccessfully — to create an exchange-traded mechanism for hedging the medical-care component of the Consumer Price Index.
“Being able to trade subcomponents is the holy grail,” said Ashton, whose Twitter handle is @inflation_guy. “Everybody has different exposure to inflation, a different experience of it. So one-size-fits-all eventually has to go away, because not everyone wants a black Model-T.”
Shiller, a Yale University economics professor, had been involved in the creation of a comparable product tied to oil prices and, later, launched one for single-family home prices. Both efforts ultimately failed, and the latest bond proposal may struggle to gain traction. Still, Ashton and Shiller say that hedging CPI components is a worthy idea whose time will come.
Consider the Risks
“There are a lot of risks people are facing without insurance — health care and education among them,” Shiller said in an interview. Global warming is another, he said. “There are all kinds of assets that should be created.”
The U.S. began issuing Treasury Inflation-Protected Securities linked to the CPI in 1997. The idea that the government could sell debt tied to health-care and education costs was among those that the Treasury Borrowing Advisory Committee presented at the end of last month. TBAC, comprising 17 bond-market professionals who relay industry opinion to the nation’s domestic-finance managers, had been asked for a report on how the U.S. could better handle its growing borrowing need.
In a list that also included Treasuries maturing in 15-20 years, perpetual horizon debt and zero-coupon bonds, TBAC said the new TIPS “are likely to result in more cost savings than those linked to the whole CPI basket.”
The current approach “is not a good hedge for investors exposed to specific inflation risks,” the report said. For example, corporate and state health-care plans might prefer TIPS indexed to medical costs, while college savings plans might like education-linked securities.
Reading TBAC’s report at his office in Morristown, New Jersey, Ashton recognized the rationale for the proposal he’d worked on with Shiller in 2007 and 2008. In 2004, he’d given a presentation on the potential for trading CPI components at a Barclays Capital inflation-linked-bond conference in Key Biscayne, Florida. At the time, Ashton was in charge of inflation derivatives at Barclays in New York.
Ashton says he predicted in Key Biscayne that within five years, people would be trading the components of inflation.
“It’s just taking longer than I thought,” he said. Ashton’s firm, Enduring Investments LLC, was founded in 2009 and helps clients hedge large or unusual inflation risks.
The topic of Ashton’s 2004 presentation aligned with work that Shiller did for his 1993 book ‘Macro Markets: Creating Institutions for Managing Society’s Largest Economic Risks.’ The book’s main idea is that financial markets lack easily created tools that would allow investors to build portfolios that address individual risks.
“Things like this take a long time to get established,” Shiller said. “People are not as calculating as economists like to assume.”
Shiller in 1999 co-founded MacroMarkets LLC, an investment manager that developed MacroShares — a legal structure for exchange-traded trusts (friendlier to individual investors than futures are) that would make distributions based on price changes in specific commodities or indexes. In 2006, it listed MacroShares Oil Up and MacroShares Oil Down, referencing crude oil.
At the time, Ashton was working for Natixis Capital Markets, making markets in inflation derivatives. He pitched Shiller’s firm on using the MacroShares model to list medical-care inflation securities, and the two took the idea to asset managers including Calpers, Pimco, TIAA-CREF and Western Asset Management.
MacroMarkets in January 2008 filed an offering document for Medical Inflation Up and Medical Inflation Down shares. Then the financial crisis hit. The oil shares stopped trading in mid-2008. MacroMarkets in mid-2009 listed Up and Down MacroShares tied to the value of the S&P Case-Shiller Composite-10 Home Price Index. They stopped trading in December 2009, though the indexes live on.
Shiller ascribes these failures — along with the broader lack of tools available to hedge specific risks — to inertia. For example, fire insurance didn’t become widespread until the mortgage industry started demanding it, even as cities were ravaged by flames on a regular basis, he said.
The financial industry could issue CPI subcomponent TIPS on its own, comparable to how bond dealers created the first zero-coupon Treasuries in the early 1980s — predating the Strips market by several years, Ashton said. That was the vision he had in Key Biscayne in 2004.
TIPS could be placed in a trust and the separate inflation exposures sold separately. The problem, he said, is that health care and education are relatively small parts of the CPI (with weights of about 8.6 percent and 3 percent).
While there are investors who might over-pay for specific types of protection, “you can’t sell them expensive enough to make the rest cheap enough to fly off the shelf,” Ashton said. That’s why direct issuance by the Treasury is probably necessary.
The Fed could assist in testing the market for such a product as it rolls off some of the Treasuries accumulated during the financial crisis, including TIPS, Ashton said. He laid out that idea in a blog post in September.
By selling specific inflation exposures and keeping the rest, the central bank “would likely have the large positive effect of jump-starting a really important market.”
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