TIPS In A Brave QE3 World

September 18, 2012


ETFs are a double-edged sword when it comes to TIPS. Yes, they are efficient, but they don’t necessarily preserve capital—which is often the rationale for investing in TIPS.

Treasury inflation-protected securities are subject to most of the same price factors as Treasury bonds, with the exception of inflation. It follows that TIPS appreciate when interest rates are declining. In a falling interest-rate environment, investors would realize capital gains by selling TIPS prior to maturity.

That matters when it comes to ETFs because TIPS ETFs generally target a specific duration, so they rarely, if ever, hold TIPS until maturity. Again, that means owners will realize either a capital gain or loss upon sale.

So, when interest rates are falling, TIPS appreciate and ETFs holding them benefit from capital gains. However, if inflation picks up and interest rates increase, TIPS ETFs tend to lag at exactly the time when many expect them to outperform. That’s the double-edged sword of TIPS ETFs.

Whereas a TIPS owner that holds the security to maturity will have the same purchasing power as when it was purchased, a trader of TIPS will more likely experience either an increase or decrease in purchasing power if interest rates are falling or rising, respectively.

Like all bonds, TIPS are a particularly good investment if interest rates decline. Conventional wisdom dictates that today’s negative yields, which are near all-time lows, can’t go much lower.

However, the Federal Reserve has promised low long-term interest rates and has simultaneously engaged in activities that stoke inflation fears.

Regardless of whether inflation rears its head, real yields on TIPS have the potential of being pushed further into negative territory if expectations for inflation increase.

If this is the case, TIPS ETFs ought to be a great investment because, like all bonds, they appreciate when interest rates decline, even if it’s into negative territory.

Ultimately, TIPS ETFs are a great product under the right circumstances, and they ought to be evaluated under the same criteria as any other government bond; that is, they should be compared to other offerings.

At the time the article was written, the author had no positions in the securities mentioned. Contact Spencer Bogart at [email protected].

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