TIPs Still Make Sense For Portfolios

By Aaron Levitt | May 29, 2013 AAA

Through their various quantitative easing and long-term refinancing operations, a variety of central banks and policy makers have injected tremendous amounts of liquidity into the markets. Many analysts and fund managers believe that these large liquidity infusions will ultimately lead to higher inflation and consumer prices down the road.

So far these events haven’t happened as overall inflation has been predominately mild.

This “mild” inflation is having its way with prices for assets designed to combat the problem. In this case we’re talking about Treasury Inflation-Protected Securities (TIPS). However, despite the recent set-backs and outflows in the TIPS marketplace, there’s still plenty of reasons why investors should consider adding to or sticking with their allocation to the bond type.

SEE: Asset Allocation In A Bond Portfolio

Still A Negative Yield

At their core, Treasury Inflation-Protected Securities are bonds that provide investors a fixed yield plus an “extra income kicker” of continually ongoing adjustments to designed offset inflation. These bonds have been used by investors as a way to play the potentially high inflationary scenarios that come with monetary easing.

Unfortunately, that strategy may have worked too well.

As investors have clamored for all things inflation-fighting, yields on various TIPS bonds have been negative for more than a year. Essentially, those who hold to these bonds to maturity are almost assured that the buying power of their investment will fall short of the inflation rate by the amount of this yield. Currently, that’s a negative 0.6% per year on 10-year TIPS bond and negative 1.3% for 5-year ones.

However, that negative yield is a little misleading. Currently, the break-even rate for a standard ten-year treasury bond versus a ten-year TIPS is around 2.35%. Basically, that means if inflation rises by more than this amount per year, TIPS holders will come out ahead. Historically, the average inflation rate since World War II has been 3.6%.

There’s plenty of potential to see that rate again even though today inflation remains tame. Demand from emerging markets for all sorts of raw materials is expanding exponentially and efforts to jump-start various economies has created a glut in the money supply. The next twenty years could see much higher prices as these conditions pan out.

The fact that TIPS are designed to adjust based on changes in the Consumer Price Index prevents erosion of purchasing power. While as total return component TIPS, probably don't make much sense, as an inflation hedge they still remain top notch.

SEE: Curbing The Effects Of Inflation

A Variety of TIPS Options

For investors, using TIPS as an insurance policy against future inflationary pressures makes sense and adding them has never been easier. The exchange traded fund (ETF) boom has provided all sorts of options for the asset class. The biggest of which is the $21 billion iShares Barclays TIPS Bond (ARCA:TIP). The ETF tracks 37 different TIPS bonds and offers cheap exposure to the inflation fighting bonds. Expenses are a rock-bottom 0.20%. Likewise, investors can use the SPDR Barclays TIPS (ARCA:IPE) to add the bonds as well.

However, there is a big problem with both TIP and IPE. That would be the fund’s durations. Just like regular bond mutual funds or ETFs, TIPS funds do not have a "maturity date" and can lose money if interest rates rise. Bonds will longer durations- TIP currently averages 8.88 years- will be hit harder. To that end, playing the short end of the maturity spectrum may be in order and the new Vanguard Short-Term Inflation-Protected Securities ETF (NASDAQ:VTIP). The fund is cheaper than larger iShares rival- at 0.10% for expenses- but also offers a duration of just 2.6 years. That shorter duration should help reduce losses when the Fed finally raises rates again.

Another option is to think globally. Rates of inflation are completely different in various parts of the world. As such, that can lead to opportunities for U.S. investors to make some extra gains on their inflation trade. The most popular way is through The SPDR DB Intl Government Inflation-Protected Bond (ARCA:WIP) as top holdings include inflation bonds from France, Poland and Japan.

Finally for those investors looking for “one stop shop” global inflation protected bond exposure, the iShares Global Inflation-Linked Bond Fund (ARCA:GTIP) and PIMCO Global Advantage Inflation-Linked Bond ETF (ARCA:ILB) could be great choices. GTIP provides passive indexing across both U.S. and international developed market TIPS, while ILB is actively managed using PIMCO’s expertise in finding values in the bond space.

SEE: 6 Popular ETF Types For Your Portfolio

The Bottom Line

Despite their recent rout and the persisting negative yields, there’s still plenty to like about TIPS bonds for investors’ portfolios. As historical longer term inflation rates are still higher than the bonds current break even points, investors are getting a bargain right now. Adding funds like the FlexShares iBoxx 3Yr Target Duration TIPS ETF (NASDAQ:TDTT) still makes sense.

At the time of writing, Aaron Levitt did not own shares in any of the companies or funds mentioned in this article.

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