Fight Inflation with these TIPS ETFs - ETF News And Commentary

By Zacks | October 11, 2012 AAA

Although current inflation is at low levels, the aggressive actions by the Federal Reserve have been raising concerns on future inflation. The rise in inflationary expectations particularly stems from the recent announcement of another round of quantitative easing (or QE3).

The Fed will buy $40 billion mortgage-backed security per month until the job market improves substantially, suggesting that purchases could continue for quite some time. The central bank also has declared that it will keep interest rates at exceptionally low levels until at least mid-2015 as well. 

While QE3 aims to improve economic growth and boost employment in the country, it could increase the burden on consumers in the form of higher prices. This is resulting in additional fears of further inflation (read: Commodity ETFs in Focus as Fed Unleashes QE3).

Still, the Consumer Price Index (CPI) currently stands at 1.692% for the month of August, up from 1.408% in July, implying that while inflation may not be an immediate concern, it could be an issue further down the road.

While precious metals are one way to protect against inflation, investors also have a few options in the bond market. Arguably the best known way in the fixed income world to protect against inflation is with ultra-safe Treasury Inflation-Protected Securities (TIPS) ETFs.

TIPS ETFs in Focus

TIPS offer robust real returns during inflationary periods, unlike their unprotected peers in the fixed income world (read: Real Return ETF Investing 101). These securities pay interest on an inflated-principal amount (principal rises with inflation) and when the securities mature, investors get either the inflation-adjusted principal or the original principal, whichever is greater.

Further, these securities provide sufficient benefits to investors through the TIPS spread, which is the difference between the yields on 10-year treasury bills and 10-year Inflation Protected treasury bills. If the inflation rate surpasses the spread, then investors would earn more on returns and vice versa.

This strategy not only combats increasing prices, but also protects future income for the long term. Thanks to these benefits, ETFs targeting this space are receiving a closer look from many over the past few years.

We have highlighted below four TIPS ETFs that all target the TIPS market, but do so in very different ways (see more ETFs in the Zacks ETF Center). Still, while they are different, any of the following could be worth a closer look by those who are seeking to protect their portfolios with safe fixed income securities in case any inflation comes down the pike in the near term:  

PIMCO 1-5 Year US TIPS Index Fund (STPZ)

Launched in 2009, this fund provides exposure to short-term securities in the TIPS market. It seeks to match the performance of the BofA Merrill Lynch 1-5 Year US Inflation-Linked Treasury Index, before fees and expenses.

The product holds 14 securities in the basket, each having maturity of at least 1 year and less than 5 years. It offers ample benefits to investors, as it is less volatile and highly correlated to inflation when compared to the broad TIPS funds.

The ETF has attracted $974.3 million of assets under management given its low risk tolerance level. The fund focuses on top rated bonds with AAA credit ratings, suggesting minimal default risk with an average maturity of just 3.05 years. Interest rate risk is also very low for the product with effective duration of 2.27 years.

The fund is cheap charging only 20 bps in fees per year. It also has a tight bid/ask spread thanks to healthy volumes of about 100,000 shares per day. The ETF returned nearly 2% so far in the year (as of September 21st) but pays little 0.55% in annual dividend yield and 0.44% on average yield to maturity (read: Escape Low Yields with These Three Bond ETFs). 

iShares Barclays Treasury Inflation Protected Securities Fund (TIP)

This is the largest ETF in the TIPS space with AUM of $23.2 billion (read: Seven Biggest Bond ETFs by AUM). The fund was launched in December 2003. The fund targets the mid-term TIPS market by tracking the Barclays U.S. Treasury Inflation Protected Securities (TIPS) Index.

With a holding of 36 securities, the product contains AAA rated bonds by Moody and AA+ by S&P, suggesting relatively higher default risk compared to the PIMCO short-term product. It allocates 56% of the assets to mid-term bonds, 25% to long-term and the rest goes to the short-term bonds; the average maturity of the fund comes to 9.30 years. Further, the fund has a relatively higher interest rate risk with an effective duration of 8.30 years.

The product is frequently traded in volumes of about 964,000 shares per day, suggesting minimal or no extra cost beyond the expense ratio of 0.20%. With an annual distribution yield of about 2.21% and average yield to maturity of 1.42%, the product has delivered healthy returns of over 5.0% year-to-date (as of September 21st).  

PIMCO 15 Year US TIPS Index Fund (LTPZ)

Unlike STPZ, this fund seeks exposure to the long-term maturity of the TIPS market. It seeks to replicate the performance of the BofA Merrill Lynch 15+ Year US Inflation-Linked Treasury Index, a subset of the Barclays Capital U.S. TIPS index (read: Long Term Treasury ETFs: Ultimate QE3 Play?).

With total assets of $398.5 million, the product is highly volatile and invests in bonds having a residual maturity of 15 years or more. The effective maturity of the fund came in at 20.56 years.

The ETF however carries a high interest rate risk given the effective duration of 12.79 years. In terms of credit quality, the fund boasts top rated bonds from Moody and S&P, suggesting lower default risk.

Launched in September 2009, the fund holds 10 securities in the basket and charges 20 bps in fees per year. With daily trading volumes of 41,000 shares per day, the fund has a relatively wide bid/ask spread that slightly increases the cost. LTPZ has generated excellent returns of more than 9% this year (as of September 21st) and pays 1.24% in annual dividend yield and 2.88% on yield to maturity.  

iShares Global Inflation-Linked Bond Fund (GTIP)

Investors seeking a global exposure to the TIPS market may find GTIP an interesting choice. The fund was introduced in May 2011 but has failed to attract more investors with an asset base of just $15.7 million. It tracks the performance of the BofA Merrill Lynch Global Diversified Inflation-Linked Index, which is a benchmark of inflation-linked bonds from around the world.

The product holds 54 securities in its basket with an average maturity of 12.09 years. It largely focuses on mid-term bonds that make up 46% of the fund. The remaining 42% is skewed towards long-term with a small 10% going to short-term securities. About two-thirds of the bonds are top notch (AAA), one-fourth investment grade and the remainder is either not rated or high yield bonds.

In terms of exposure, the assets are tilted towards American securities with 35% share, although bonds from the UK, Brazil and France round out the top four with a combined 42% share in the basket.

The product is quite expensive relative to the three aforementioned ETFs as it charges 40 bps in annual fees from investors. In addition, the low trading volume increases the cost of the product in the form of a wide bid/ask spread.

Despite its unpopular nature, the fund produced relatively impressive returns of 4.60% year-to-date (as of September 21st) with an annual yield of 2.10% (read: Top Four High Yield Bond ETFs).

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