Fresh off the heels of a third round of quantitative easing,
TIPS ETFs are in the spotlight, as investors wonder how best to
protect their portfolio against the risk of inflation.
So, how do TIPS work, and are ETFs efficient wrappers to access
the TIPS market?
TIPS, or Treasury inflation-protected securities, function much
like normal Treasury bonds except that the principal amount is
adjusted based on increases and decreases in the headline inflation
figure, as measured by the consumer price index, or CPI.
In periods where CPI increases with inflation, so too will the
principal on TIPS. When CPI decreases with deflation, so too does
TIPS offer a fixed percentage semiannual coupon based on the
principal; so the coupons of TIPS also rise and fall with inflation
It's worth noting that, taxwise, TIPS represent an impediment
for some investors. All gains to principal are taxed in the year
that principal is adjusted. So, while principal is not repaid until
maturity, investors are taxed on gains they haven't actually
received. They are, however, exempt from state and local taxes.
By purchasing TIPS, investors are locking in a real yield.
Currently, the real yield that investors are locking in is
negative. This implies, quite literally, that investors are willing
to guarantee a small loss to their purchasing power to hedge
against the risk of losing even more.
As of Sept. 17, investors are locking in a real yield of -1.58
percent on five-year TIPS. Comparatively, investors in Treasury
bonds secured a nominal yield of 0.73 percent. From these two
yields we can "back out" that implied inflation is 2.31
By extension, if inflation is higher than 2.31 percent, TIPS
investors will be better off; otherwise, Treasury bonds will
For example, let's say the inflation rate rises to 3.5 percent.
That would mean the
yield secured on the Treasury bond would be -2.77 percent-less than
the real yield that could have been secured by investing in TIPS.
The reverse is also true.
Several ETFs offer TIPS exposure, and among them are:
- iShares Barclays TIPS Bond Fund (NYSEArca:TIP) and the Schwab
U.S. TIPS ETF (NYSEArca:SCHP) for broad maturity exposure
- Pimco 1-5 Year U.S. TIPS (NYSEArca:STPZ) for short-term
- Pimco 15+ Year U.S. TIPS ETF (NYSEArca:LTPZ) for long-term
So, are ETFs an efficient product for accessing TIPS?
ETFs are a double-edged sword when it comes to TIPS. Yes,
they are efficient, but they don't necessarily preserve
capital-which is often the rationale for investing in TIPS.
Treasury inflation-protected securities are subject to most of
the same price factors as Treasury bonds, with the exception of
inflation. It follows that TIPS appreciate when interest rates are
declining. In a falling interest-rate environment, investors would
realize capital gains by selling TIPS prior to maturity.
That matters when it comes to ETFs because TIPS ETFs generally
target a specific duration, so they rarely, if ever, hold TIPS
until maturity. Again, that means owners will realize either a
capital gain or loss upon sale.
So, when interest rates are falling, TIPS appreciate and ETFs
holding them benefit from capital gains. However, if inflation
picks up and interest rates increase, TIPS ETFs tend to lag at
exactly the time when many expect them to outperform. That's the
double-edged sword of TIPS ETFs.
Whereas a TIPS owner that holds the security to maturity will
have the same purchasing power as when it was purchased, a trader
of TIPS will more likely experience either an increase or decrease
in purchasing power if interest rates are falling or rising,
Like all bonds, TIPS are a particularly good investment if
interest rates decline. Conventional wisdom dictates that today's
negative yields, which are near all-time lows, can't go much
However, the Federal Reserve has promised low long-term interest
rates and has simultaneously engaged in activities that stoke
Regardless of whether inflation rears its head, real yields on
TIPS have the potential of being pushed further into negative
territory if expectations for inflation increase.
If this is the case, TIPS ETFs ought to be a great investment
because, like all bonds, they appreciate when interest rates
decline, even if it's into negative territory.
Ultimately, TIPS ETFs are a great product under the right
circumstances, and they ought to be evaluated under the same
criteria as any other government bond; that is, they should be
compared to other offerings.
At the time the article was written, the author had no positions
in the securities mentioned. Contact Spencer Bogart at
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