Why TIPS Still Make Sense

By Aaron Levitt | January 16, 2012 AAA

As anxiety about the health of the global economy continues to remain high, investors have plowed into all sorts of treasury bonds. Over the last few years, U.S. government bonds have had an impressive total return and broad-based funds, like the iShares Barclays 7-10 Year Treasury (ARCA:IEF), have surged to new highs. In all this enthusiasm for safety, yields have been pushed to extremely low levels. In the case of treasury inflation protected securities or TIPS, that yield is now negative. Despite the current negative yield, TIPS still have appeal for longer oriented portfolios.
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A Banner 2011
Overall, TIPS produced double digit returns throughout 2011. These gains not only bested broad bond measures, but almost every major stock index as well. As the Federal Reserve has kept short-term interest rates at puny levels and investors looked for safe havens, bond prices have rallied. So much so, that in December, five-year TIPS sported a real yield of negative 0.96%.

However, that negative yield is a little misleading. These bonds are designed to provide a fixed coupon plus a rate that is adjusted based on changes in the Consumer Price Index. This prevents erosion of purchasing power. So as inflation increases, investors gain that, plus the bonds coupon rate. While as total return component TIPS, probably don't make much sense, but as an inflation hedge they still remain top notch.

Inflation isn't a guarantee. However, the possibility is gaining momentum. This uncertainty towards an inflationary environment stems from the notion of rising commodity prices, a falling dollar and countless rounds of monetary stimulus. Over the past 20 years, consumer prices have climbed an average of 2.6% annually. However, the longer outlook for inflation could be much higher.

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 20 years could see much higher prices as these conditions pan out.

Currently, the break-even rate for a standard ten-year treasury bond versus a ten-year TIPS is around 2.08%. If inflation rises by more than this amount per year, TIPS make a much better play. (If you want to protect your portfolio from inflation, all you need are a few TIPS. For more, see Treasury Inflation Protected Securities.)


Adding Some Inflation Protection
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 boom has provided all sorts of options for the asset class.

The largest fund in the sector is the
iShares Barclays TIPS Bond (ARCA:TIP). With nearly $22 billion in assets, the fund tracks a variety of TIPS maturities and provides broad exposure to the asset class. The ETF offers zero in the way of current distribution yield, but as inflation picks up, payouts could resume. Similarly, SPDR Barclays Capital TIPS (ARCA:IPE) provides broad exposure as well.

Just like regular bond mutual funds or ETFs, TIPS funds do not have a "maturity date" and can lose money if interest rates rise. To that end, playing the short end of the maturity spectrum may be in order. Bond superstars PIMCO offers the PIMCO 1-5 Year US TIPS Index ETF (ARCA:STPZ). The fund allows investors to access this segment of the asset class and should help protect them in a rising rate environment.

Other nations have followed the United States' lead and have created TIPS products. The SPDR DB Intl Government Inflation-Protected Bond (ARCA:WIP) gives investors a chance to diversify their inflation investments outside the United States. Top holdings include inflation bonds from France, South Africa and Japan. While the
iShares Glob Inflation-Linked Bond Fund (ARCA:GTIP) can provide investors with a TIPS one-stop-shop. The fund holds both U.S. and international inflation protected bonds under one ticker. (For related reading on ETFs, see Using ETFs To Build A Cost-Effective Portfolio.)

The Bottom Line
As investors have rushed into the safety of bonds, yields have been pushed to their lowest limits. For treasury inflation protected securities, that yield is now negative. However, the asset class still can be great long-term value if inflation expectations continue to be high. For investors, adding a dose of TIPS via funds like the Schwab U.S. TIPS ETF (ARCA:SCHP) can be a great insurance policy.

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

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