Fresh off the heels of a third round of quantitative easing, TIPS ETFs are in the spotlight, as investors wonder how best to protect their portfolio against the risk of inflation.
So, how do TIPS work, and are ETFs efficient wrappers to access the TIPS market?
TIPS, or Treasury inflation-protected securities, function much like normal Treasury bonds except that the principal amount is adjusted based on increases and decreases in the headline inflation figure, as measured by the consumer price index, or CPI.
In periods where CPI increases with inflation, so too will the principal on TIPS. When CPI decreases with deflation, so too does your principal.
TIPS offer a fixed percentage semiannual coupon based on the principal; so the coupons of TIPS also rise and fall with inflation and deflation.
It’s worth noting that, taxwise, TIPS represent an impediment for some investors. All gains to principal are taxed in the year that principal is adjusted. So, while principal is not repaid until maturity, investors are taxed on gains they haven’t actually received. They are, however, exempt from state and local taxes.
By purchasing TIPS, investors are locking in a real yield. Currently, the real yield that investors are locking in is negative. This implies, quite literally, that investors are willing to guarantee a small loss to their purchasing power to hedge against the risk of losing even more.
As of Sept. 17, investors are locking in a real yield of -1.58 percent on five-year TIPS. Comparatively, investors in Treasury bonds secured a nominal yield of 0.73 percent. From these two yields we can “back out” that implied inflation is 2.31 percent.
By extension, if inflation is higher than 2.31 percent, TIPS investors will be better off; otherwise, Treasury bonds will outperform TIPS.
For example, let’s say the inflation rate rises to 3.5 percent. That would mean the real yield secured on the Treasury bond would be -2.77 percent—less than the real yield that could have been secured by investing in TIPS. The reverse is also true.
Several ETFs offer TIPS exposure, and among them are:
- iShares Barclays TIPS Bond Fund (NYSEArca: TIP) and the Schwab U.S. TIPS ETF (NYSEArca: SCHP) for broad maturity exposure
- Pimco 1-5 Year U.S. TIPS (NYSEArca: STPZ) for short-term exposure
- Pimco 15+ Year U.S. TIPS ETF (NYSEArca: LTPZ) for long-term exposure
So, are ETFs an efficient product for accessing TIPS?
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