Is It Finally Time For TIPS?

By Aaron Levitt | July 01, 2014 AAA

Once the Federal Reserve unveiled its programs of easing and bond buying designed to reignite a stalled U.S. economy, there has been a persistent idea that such money-printing would drive up inflation. Over the last few years, the consumer price index (CPI) has been pretty calm and the dire warnings about hyperinflation haven’t exactly panned out.

While we are nowhere near reaching Zimbabwe-style hyperinflation just yet, the Fed did get a bit of shocking news: prices are on the rise.

For investors, that could mean that an old standby way to preventing inflation – Treasury Inflation-Protected Securities or TIPS – could finally be a good buy in the year ahead. (For more, see: An Introduction To Treasury Inflation-Protected Securities.)

Highest Point In Years

For inflation hawks, things are starting to get a bit dicey. Namely, the price of consumer goods and services. The index for personal consumption expenditures (PCE) is at its highest level in more than a year and a half. The rate jumped 1.8% in May to reach the highest level since October 2012. This compares to just a 0.8% reading in February. The effects were felt across the board by shoppers, with the largest price increases occurring at grocery stores, gas stations and in their utility bills. Energy prices were up 5.8% last month, while food increased by 2.1%.

Meanwhile, the other measure of inflation – the CPI – also ticked higher. The Labor Department’s measure of inflation rose an unadjusted 2.1% over the past 12 months. And considering that the Fed has annual target rate of 2% for inflation, things are starting to get interesting.

That where TIPS come in.

TIPS are bonds that provide investors a fixed yield plus an “extra boost” of continually ongoing adjustments to designed offset inflation. These bonds can be used by investors as a way to play potentially high inflationary scenarios. The fact that they are designed to adjust based on changes in the CPI prevents erosion of purchasing power.

That fact also sets up an interesting play as well.

Many analysts now believe that the Fed is “behind” the inflationary curve. Its favorite benchmark – the PCE – is still below the 2% rate it needs to begin tightening. However, the CPI is above that 2% metric. Analysts believe that the CPI rate of inflation will rise to 2.29% before the Fed begins raising interest rates. Already, Fed Chairwoman Janet Yellen called the CPI metric “just noise.” That sets-up an interesting arbitrage scenario for investors in TIPS.

Already, the institutional investors have begun adding more TIPS to their portfolios. The Treasuries latest auction on June 19 was over-subscribed by 2.76 times. (For related reading, see: Fighting Inflation Beyond TIPS.)

Making a TIPS Play

For investors, using TIPS as an insurance policy against future inflationary pressures makes sense given the recent jumps in PCE and CPI. And adding them has never been easier. The exchange traded fund (ETF) boom has provided all sorts of options for the asset class. The easiest of which is the $13 billion iShares TIPS Bond ETF (TIP).

The fund tracks 39 different inflation-protected securities and offers cheap exposure to U.S. inflation fighting bonds. Expenses are a rock-bottom 0.20%. Likewise, the Schwab US TIPS ETF (SCHP) offers dirt cheap exposure as well. SCHP only charges 0.07%. The only problem with these funds is their duration might actually hurt them.

Just like regular bond funds, TIPS funds do not have a "maturity date" and can lose money if interest rates rise. Bonds will longer durations – TIP currently averages 7.54 years – will be hit harder. Now, if Yellen continues to be "behind the curve” for a while, that won’t matter. But when interest rates do rise, TIPS, along with other intermediate or long duration TIPS funds, such as the PIMCO 15+ Year U.S. TIPS Index ETF (LTPZ), could fall hard.

To that end, shortening up duration risk is key. The $2 billion FlexShares iBoxx 3 Yr Target Duration TIPS ETF (TDTT) seeks to limit investor’s duration to just three years. Likewise, the Vanguard Short-Term Inflation-Protected Securities ETF (VTIP) drops its duration down to just 2.6 years. TDTT does yield more than VTIP, as it barbells both one- and five-year TIPS to get that three-year duration. Both make ideal selections to play inflation, while addressing the risk of rising rates.

Finally, investors don’t need to stay in the U.S. to get their inflation protection fix. Rates of inflation are completely different in various parts of the world. That can lead to opportunities for U.S. investors to make some extra gains on their inflation trade. The $956 million SPDR DB International Government Inflation-Protected Bond ETF (WIP) tracks TIPS from a variety of developed and emerging market nations. (For related reading, see: Why TIPS Still Make Sense.)

The Bottom Line

Inflation hasn’t been a problem for the last few years, but that could be about to change. Both key measures of inflation have gone up. That could mean it’s finally time for investors to embrace Treasury Inflation-Protected Securities again.

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