The document discusses the risks of deflation and inflation for fixed income investments and the need for a segmented approach. It notes that deflation would help Treasuries but hurt corporates, while inflation would help TIPS and hurt longer-term Treasuries and corporates. The author recommends investing in exchange-traded funds to gain exposure to various segments of the US and international fixed income markets to navigate changing macroeconomic conditions.

1. Getting Granular in Fixed Income
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Imperatives wrought by emerging deflation/inflation risks
By Robert Dubois
October 21, 2009
During the past year, much has been said and written about inflation risk. And more recently,
there has been increased chatter regarding deflation risk as well – with some analysts discussing
the two as a sequential possibility, with deflation striking first.
Nobody can say with certainty how the deflation/inflation dynamic will play or precisely when
significant shifts will occur.
We can say with confidence, however, that the macro-economic environments of 2012 and 2015
will be considerably different from what we see today or the macro environment that prevailed
prior to mid-2007.
The secular declines in interest and inflation rates that emerged following the 1987 crash and in
the wake of the late 1980s S&L crisis have been definitively constructive to both equity and
bond performance over the past twenty years. A progressively weaker dollar in the 2000s and a
consumer credit bubble that got rolling in the 90s, but exploded in the 2000s, were also
constructive to equities and bonds of nearly all stripes.
Looking ahead, though, expectations are generally for historically wide swings in
deflation/inflation rates, interest rates, currency exchange rates and, rather generically, in risk
appetites. From an investment and risk management perspective, deflationary and inflationary
swings are likely to have pronounced and highly varied impacts across segments of fixed income
markets. Accordingly, greater discernment between subsets of the broader fixed income asset
class is likely to be of far greater importance in the coming decade than it has at any time in
recent decades.
For example, a severe deflationary cycle would – as Pimco’s Bill Gross recently suggested –
likely be supportive of Treasuries across the maturity spectrum, but in the intermediate and long
segments in particular. Corporates, though, would suffer from the flight to safety of Treasuries to
an extent dependent on the scale and intensity of a deflationary turn.
A severe inflationary cycle, however, would be constructive to TIPS and short-term bonds while
quite damaging to longer maturity Treasuries and corporates.
Also posing challenges to the management of bond portfolio risk is the rapidly evolving dollar
Contents are for information purposes only and should not be regarded as a recommendation or as an offer to sell or as a solicitation of an offer to buy any financial
product or service or as an official statement of Trend Modus Capital Management LLC or Robert Dubois. Neither Trend Modus nor Robert Dubois can guarantee
this information to be complete or accurate and it should not be relied upon as such. Investment strategies of any kind engender risk, including potential loss of
principal. Past performance is no guarantee of future results.
Trend Modus Capital Management LLC – 7300 W. 110th St, Suite 700, Overland Park, KS 66210 – 913.980.6382(tel)/913.904.9600(fax) – rdubois@trendmodus.com

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relationship relative to both developed and emerging market currencies. A rapidly expanding
Treasury bond supply across economies, especially those running large and protracted current
account deficits such as the U.S., is an important shaper of interest and exchange rates.
And, too, the printing of money is in vogue – in the U.S. it is currently taking on the form of
repurchase of Treasuries by the Federal Reserve Bank even as the issuance of Treasuries is
running roughly triple the pace of a year ago. The FRB/Treasury has also become the preferred
parking garage for significant volumes of mortgage and consumer debt-backed securities posted
as collateral by major banks for funding at cheap short-term borrowing rates.
The need to consider staying tactically nimble in fixed income and the benefits of knowing what
you have in ETFs, on a daily basis, make segmentation of the broader fixed income asset class in
ETFs an important exercise for all risk managers.
Here’s a look at what most investors would need to cover every major segment of the broader
fixed income asset class. There are no less than six noteworthy U.S. segments and three
international segments.
US Government issues – Treasuries: SHY (1-3 Yr), IEI (3-7 Yr), IEF (7-10 Yr), TLH (10-20),
TLT (20+ Yr), PLW (1-30 Yr Laddered).
US Agency issues – Mortgage backed: MBB, MBG
US Corporates: Investment-grade, LQD: High-yield, HYG, JNK
US Municipals: TFI; SHM (short-term)
US Convertibles: CWB
US TIPS: TIP; STPZ (short-term)
International developed market treasuries: BWX (local currency-denominated); BWZ (short-
term; local currency-denominated)
International emerging market treasuries: PCY (dollar-denominated), EMB (dollar-
denominated)
International TIPS: WIP (local currency-denominated)
Understanding performance and risk attributes of individual segments of the fixed income asset
class will be far more important over the next three to five years than at any time during the past
twenty years. Where a diversified aggregate bond holding might have sufficed during the secular
decline in interest and inflation rates, massive performance divergences might render fixed
income segmentation critical in the potentially dramatically different interest rate, inflation rate
and dollar value environments going forward.
Contents are for information purposes only and should not be regarded as a recommendation or as an offer to sell or as a solicitation of an offer to buy any financial
product or service or as an official statement of Trend Modus Capital Management LLC or Robert Dubois. Neither Trend Modus nor Robert Dubois can guarantee
this information to be complete or accurate and it should not be relied upon as such. Investment strategies of any kind engender risk, including potential loss of
principal. Past performance is no guarantee of future results.
Trend Modus Capital Management LLC – 7300 W. 110th St, Suite 700, Overland Park, KS 66210 – 913.980.6382(tel)/913.904.9600(fax) – rdubois@trendmodus.com