Exchange-traded funds, or ETFs, that invest in U.S. Treasury inflation-protected securities, or TIPS, present a very convenient way for investors to gain exposure to fixed-income instruments guaranteed by the U.S. government that are protected against inflation. TIPS are issued with a fixed interest rate and come with maturities of five, 10 and 30 years. The principal balance of TIPS changes with the Consumer Price Index, or CPI. With inflation, the principal rises, while deflation causes the principal to go down. Since the principal amount fluctuates with the CPI, so does the actual interest rate paid on TIPS. The principal repaid at maturity is either the adjusted principal or the original one, whichever is greater. Thus, investors are protected against deflation.
As of August 2015, TIPS ETFs have generated an average annual return of about 3 to 4% over the last five to 10 years. Due to significant deflationary pressures and the rise of interest rates in the United States over the last three years, TIPS ETFs have demonstrated negative returns in low single digits.
iShares TIPS Bond
The iShares TIPS Bond ETF (NYSEARCA: TIP) tracks the performance of the Barclays U.S. Treasury Inflation Protected Securities TIPS Index, which is composed of TIPS with maturities ranging from one to 20-plus years. The majority of the fund's holdings are concentrated on securities with maturities from five to seven years, and the fund's weighted average maturity is 8.6 years. The 12-month yield stands at 0.23%, and investors can expect to receive a weighted yield to maturity of 1.76%. TIP's effective duration is 7.9 years, making it somewhat sensitive to the changes in interest rates. The fund's annual expense ratio is 0.2%.
This ETF is most appropriate for investors who are interested in investing in TIPS with effective durations of about eight years and do not mind their holdings being sensitive to the changes in the interest rate, which is expected to rise within the next one or two years in the U.S.
Vanguard Short-Term Infl-Prot Secs ETF
The Vanguard Short-Term Infl-Prot Secs ETF (NASDAQ: VTIP) tracks the performance of the Barclays U.S. Treasury Inflation-Protected Securities TIPS 0-5 Year Index, which is composed of TIPS that mature in less than five years. As of August 2015, VTIP holds 16 different bonds with the average coupon rate of 0.9%. The fund's effective duration stands at 2.6 years, making it much less sensitive to changes in the benchmark interest rate but much more responsive to changes in CPI. For this reason, VTIP offers strong protection against inflation compared to other ETFs with longer effective duration. VTIP's yield to maturity is 1%, and it has an annual expense ratio of 0.1%, which is much lower than the 0.17% expense ratio for similar funds.
VTIP is most appropriate for investors who are concerned about unexpected inflation but at the same time want exposure to TIPS with shorter durations that are less sensitive to changes in interest rates in the U.S.
PIMCO 15+ Year US TIPS ETF
The PIMCO 15+ Year US TIPS ETF (NYSEARCA: LTPZ) seeks to obtain investment results that correspond to those of the BofA Merrill Lynch 15+ Year US Inflation-Linked Treasury Index, which is composed of TIPS with maturities of at least 15 years. As of August 2015, LTPZ holds seven different TIPS maturing between 2032 and 2045, and the fund's effective maturity is about 26 years, while its effective duration stands at 22 years. LTPZ has a yield to maturity of 2.9% and an average coupon rate of 1.5%. The fund's expense ratio is 0.2%. Not only is the fund exposed to inflation rate changes, but it is also highly sensitive to interest rate changes. It demonstrates a five-year standard deviation of 11.5%, which is double that of the TIP and VTIP ETFs.
LTPZ is most suitable for investors who are interested in investing in TIPS with much longer maturity and have a high risk tolerance to interest rate risks.
PIMCO Global Advtg Infl-Lkd Bd Actv ETF
PIMCO Global Advtg Infl-Lkd Bd Actv ETF (NYSEARCA: ILB) is an actively managed ETF that invests in investment-grade, inflation-linked bonds with a heavy concentration on TIPS. The fund's benchmarks are the GDP-weighted Global Advantage Inflation-Linked Bond Index and the Barclays Capital Universal Government Inflation-Linked Bond Index. Around 74% of ILB's holdings are invested in U.S. TIPS, while the remainder is spread out among inflation-linked bonds issued by Denmark, South Africa, Turkey, Canada and the United Kingdom. Due to the fund's effective duration of 7.7 years, it is not very sensitive to interest rate changes. Because of exposure to developed countries and emerging market countries, ILB's yield to maturity stands at 4.7%. It has an expense ratio of 0.6%.
This fund is most appropriate for investors who are looking for exposure to U.S. TIPS but also do not mind having inflation-linked bonds issued by emerging market countries, which offer higher rates of return when compared to ETFs investing only in U.S. TIPS.
ProShares UltraShort TIPs
For those who are bearish on TIPS and want to obtain a short position on them, the ProShares UltraShort TIPS fund offers daily investment results that correspond to two times the inverse, or -2x, of the daily performance of the Barclays U.S. Treasury Inflation Protected Securities TIPS Index. Unlike long TIPS ETFs, this fund does not invest in TIPS, but instead holds derivative instruments such as swaps that provide daily short positions on the benchmark index. Because TPS' returns are compounded daily, the performance of the fund may significantly differ from two times the inverse of total returns on the underlying index in the long-term. Investors should be careful about holding this fund for extended periods of time. Also, the fund exhibits a high volatility with its three-year standard deviation of 10.3%. It has a somewhat high expense ratio of 0.95%.
This fund is most appropriate for investors who have bearish views on the performance of U.S. TIPS in the short-term and want to obtain speculative positions that bet on the price decline of TIPS. Because the fund provides leveraged returns, investors should carefully evaluate TPS before investing in this fund.