TIPS In A Brave QE3 World

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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 your principal.

TIPS offer a fixed percentage semiannual coupon based on the principal; so the coupons of TIPS also rise and fall with inflation and deflation.

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 percent.

By extension, if inflation is higher than 2.31 percent, TIPS investors will be better off; otherwise, Treasury bonds will outperform TIPS.

For example, let's say the inflation rate rises to 3.5 percent. That would mean the real 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 exposure
  • Pimco 15+ Year U.S. TIPS ETF (NYSEArca:LTPZ) for long-term exposure

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, respectively.

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 lower.

However, the Federal Reserve has promised low long-term interest rates and has simultaneously engaged in activities that stoke inflation fears.

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 sbogart@indexuniverse.com.


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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , ETFs

Referenced Stocks: LTPZ , SCHP , STPZ , TIP

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