Deutsche Bank introduces two PowerShares ETNs designed to provide TIPS alternatives

By Emma Trincal

New York, Dec. 6 - Deutsche Bank AG, London Branch introduced two new exchange-traded notes that offer investors exposure to U.S. inflation or deflation expectations but with less exposure to interest rate risk than a long or short position in Treasury Inflation-Protected Securities, according to a news release from Deutsche Bank and Invesco PowerShares Capital Management, LLC.

"The inflation ETNs and deflation ETNs are the first exchange-traded notes to provide investors with direct exposure to U.S. inflation and deflation expectations," Deutsche Bank said in an FWP filing with the Securities and Exchange Commission.

Deutsche Bank issued $4 million of 0% PowerShares DB US Inflation ETNs due Nov. 30, 2021 linked to the DBIQ Duration-Adjusted Inflation index and the DB 3-Month T-Bill index, according to a 424B2 filing with the Securities and Exchange Commission.

The bank also issued $4 million of 0% PowerShares DB US Deflation ETNs due Nov. 30, 2021 linked to the DBIQ Duration-Adjusted Deflation index and the DB 3-Month T-Bill index.

Offsetting with Treasuries

The inflation ETNs attempt to isolate U.S. inflation by going long TIPS and short Treasuries, according to company filings.

If inflation does go up, investors will generate a positive return because TIPS will outperform Treasuries.

In the release, Martin Kremenstein, chief investment officer of db-X North America, Deutsche Bank's exchange-traded platform, presented the two ETNs as "TIPS-based products."

"By establishing an offsetting position in U.S. Treasuries and neutralizing the impact of changes in the interest rates, we believe the PowerShares DB US Inflation and Deflation ETNs can more effectively target long or short exposure to inflation for investors," Kremenstein said.

For investors who believe that deflation will prevail, the deflation ETNs adopt the opposite strategy with a short exposure to TIPS and a long position in Treasuries, according to the filings.

In a deflation environment, the deflation ETNs would generate positive returns as Treasuries would appreciate in price and therefore outperform the TIPS.

"I don't think you can argue with the strategy," a bond trader said.

"If you own Treasuries and you're short TIPS and the market expects more deflation, you'll do quite well."

Pure exposure

The principal amount of TIPS generally increases with inflation and decreases with deflation, as measured by the Consumer Price Index. Deutsche Bank and Invesco noted that TIPS market prices are also sensitive to changes in interest rates, which can diminish their ability to provide pure exposure to inflation on a mark-to-market basis.

"What they're doing here is removing interest rate exposure," said Jim Delaney, portfolio manager at Market Strategies Management.

"With this product, you're taking away the interest rate risk and making it a pure inflation play."

Delaney said that mitigating interest rate exposure was commonly done in the corporate bond market.

"If a corporate bond dealer buys some corporate paper from a customer, he'll sell the same amount of Treasuries with the same maturity. That way, the dealer can remove the interest rates risk from the bond. The only risk they have is corporate risk," he said.

"It's not necessarily a better strategy than owning or shorting TIPS. It's just more of a pure play. It separates the interest rate risk from the inflation risk," he said.

Other plays

Sources said that the concept behind the notes was eye-catching because of the reduced interest rate risk. Yet, some also said that they would rather use more traditional approaches.

"I would absolutely not do that," the bond trader said.

"I'd rather own the TIPS, which are obligations of the U.S. government, than subjecting myself to counterparty risk."

A financial adviser agreed.

"I haven't come across other vehicles that give you direct exposure to inflation expectations," said Frederick Wright, partner and chief investment officer at Smith & Howard Wealth Management.

"The inflation ETNs are designed to give you some upside if inflation goes up. But you have to be very comfortable with the credit risk of Deutsche Bank."

"It could be a good idea because you want to be able to hedge against inflation," said a portfolio manager.

"But the question is whether or not it's the right instrument.

"We buy foreign currencies, we buy high-dividend stocks. Utilities stocks for instance are very good because utilities are allowed to pass rising costs to customers, so those stocks have built-in inflation protection.

"There are easier ways to hedge against inflation.

"I don't see retail investors in this type of product. I imagine that kind of demand came from institutional investors."

Another concern was whether returns would meet investors' expectations.

"The returns have to be modest. You'll have to do it on a leveraged basis to get some money," the bond trader said.

"When you own TIPS, you're exposed to two risks: interest rate exposure and inflation exposure," said Delaney.

"You always get paid for taking risks. So with TIPS you get compensated for both.

"Here, they've removed the interest rate risk. You only have the inflation risk. My take is that you're going to earn less."

Delaney said that the gains for someone buying the inflation ETNs would come from the difference in yields between the long position in TIPS and the short position in Treasuries.

"On the long TIPS position, you earn a coupon. On the short Treasury, you pay a coupon. That can't be that much. You'd better leverage the difference, otherwise why not just buy a CD?"

Delaney said that inflation tends to rise incrementally, which is why he does not expect high returns from the notes.

"It's not like inflation is going to jump to 15% tomorrow. This inflation thing is not a trade I see value in," he said.

Up to $200 million planned

For each series of ETNs, Deutsche Bank issued 80,000 notes at par of $50. All of them may be held initially by Deutsche Bank Securities Inc., the underwriter. The company plans to issue up to $200 million of notes. Additional notes may be offered from time to time at prevailing prices at the time of sale.

The Inflation ETNs and the Deflation ETNs were approved for listing on the NYSE Arca under the symbols "INFL" and "DEFL," respectively.

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