Fresk: TIPX, A New TIPS Approach

November 27, 2013

For investors seeking a fresh way to fine-tune TIPS use, ‘TIPX’ looms large.

This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today’s article features Clayton Fresk, CFA, portfolio management analyst at Georgia-based Stadion Money Management.

Much has been made recently about the potential end of the 30-year bull market in interest rates and the reactions of many investors to shorten the duration of their fixed-income holdings.

But because of extremely low rates on the shortest part of the curve, advisors must be cautious not to shorten too extensively as they might miss potential yield opportunities. One potential trade idea to accomplish this is to move exposure off the longest part of the curve and focus on the intermediate part of the curve.

Thankfully, a new exchange-traded fund, the SPDR Barclays 1-10 Year TIPS ETF (TIPX) that came to market in May of this year can help advisors looking to better mitigate the aforementioned interest-rate risks within a broad portfolio while maintaining a focus on inflation protection, as I’ll discuss in detail below.

TIPX has a cheap annual expense ratio—15 basis points, or $15 for each $10,000 invested. Given that it’s relatively new, the fund is trading with a round-trip bid/ask spread of 83 basis points, according to data compiled by IndexUniverse’s ETF Analytics unit.

However, because of the extremely liquid nature of the underlying holdings, it may be possible to transact in the fund at improved levels via authorized participants.

And it may be worth it, as I’ll explain.

Shortening Duration

In certain sectors of the fixed-income ETF universe, an advisor can easily shorten duration off the long end into intermediates via available ETFs. In Treasurys, an advisor can move along various points on the yield curve, with a few examples being:

  • Broad Treasurys via GOVT (B-91) into intermediate Treasurys via ITE (B-98)
  • 20-plus-year Treasurys via TLT (A-72) into 7- to 10-year Treasurys via IEF (A-50)

Within investment-grade credit, an advisor can conduct a similar trade via:

  • Broad corporates via LQD (A-64) into intermediate corporates via ITR (B-96)
  • 10-plus-year credit via CLY (C-85) into intermediate credit via CIU (A-88)

However, up until recently, an advisor could not move into the intermediate part of the TIPS curve via an ETF.

There are a handful of broad TIPS names available, such as:

Additionally, there has been a boom in short-duration TIPS, all of which limit exposure to five years and less. They are:

There are also a few targeted-duration TIPS names—the FlexShares iBoxx 3-Year Target Duration TIPS ETF (TDTT | B-45) the FlexShares iBoxx 5-Year Target Duration TIPS ETF (TDTF | B-74), which target either a three- or five-year duration.

But there hasn’t been a way to capture the broad intermediate part of the TIPS curve—until now.

As I noted above, earlier this year, that issue was solved with the addition of TIPX to the TIPS ETF lineup. This ETF invests in the 1- to 10-year part of the TIPS curve.

There are a few reasons it could be advantageous for advisors to use TIPX as part of the TIPS allocation in a portfolio:

Limited Duration

This seems somewhat obvious given the fund’s index of 1- to 10-year TIPS versus a broad benchmark. However, because of the nature of the TIPS market, an advisor using a broad TIPS fund may be exposed to longer duration as compared with other sectors’ broad exposure. For example, here are a few comparisons of the durations of broad and intermediate ETFs in different sectors:

  • GOVT (iShares Broad Treasury): 5.0-year duration, 1.7 years in 20-plus-year key rate exposure
  • ITE (SPDR Intermediate Term Treasury): 3.7-year duration, zero years in 20-plus-year key rate exposure
  • CFT (iShares Broad Credit): 6.6 year duration, 2.7 years in 20+ year-key rate exposure
  • CIU (iShares Intermediate Credit): 4.3 year duration, zero years in 20+ year key-rate exposure
  • IPE (SPDR Broad TIPS): 8.9-year duration, 3.7 years in 20-plus-year key rate exposure
  • TIPX (SPDR 1-10 TIPS): 5.5-year duration, zero years in 20-plus-year key-rate exposure

As compared with broad Treasurys and/or credit, a broad TIPS fund has a significantly higher duration (8.9 versus 5.0-6.6), as well as a higher allocation of its curve exposure to the 20-plus-year part of the curve. If the market were to experience a curve steepener where long end rates climbed more, relative to the rest of the curve, this higher allocation to the long end would have a greater adverse effect on the portfolio.

An easy solution to the duration problem could be to use the plethora of short-duration TIPS ETFs available. However, there are some limitations to these funds.

 

Breakeven Exposure

As mentioned, a potential trade for an advisor worried about long-end exposure in a broad TIPS fund would be to use a short-duration TIPS ETF.

A trade-off for this move in duration would also be a trade-off in the inflation breakeven exposure to which an advisor would be getting exposure.

For this comparison, I’ll use the following indexes to represent breakeven exposures going back to October 2004, and I’ll use monthly data:

  • Long: US Breakeven 30 Year (Bloomberg ticker USGGBE30)
  • Intermediate: US Breakeven 10 Year (Bloomberg ticker USGGBE10)
  • Short: US Breakeven 2 Year (Bloomberg Ticker USGGBE02)

Over the time period measured, the average breakeven levels are as follows:

  • Long: 243 basis points
  • Intermediate: 220 basis points
  • Short: 150 basis points

Therefore, an advisor moving from long-to-intermediate breakeven exposure would be giving up, on average, 23 basis points of breakeven exposure. This compares with the average 93 basis point exposure an advisor would be giving up going from long-to-short breakeven exposure.

As a comparison, here is a look at the historical option-adjusted spread (OAS) of the long, intermediate and short-term investment-grade credit indexes:

  • Long: 189 basis points
  • Intermediate: 157 basis points
  • Short: 129 basis points (60 basis points give-up from long)

Historically, the breakeven curve for TIPS is steeper than the credit curve. Therefore, advisors will experience more “give-up” of exposure sliding down the TIPS curve than they would experience sliding down the credit curve.

Additionally, short-duration breakevens are historically much more volatile than intermediate- and/or long-term breakevens. Using the time period above, the standard deviation is 3 to 4 times higher for the short-term breakevens. This same relationship does not hold true for investment-grade credit, where short-term OAS standard deviation is in the 1 to 1.5 times range.

Conclusion

The recent addition of TIPX has filled the gap in ETF exposure in the intermediate part of the TIPS market.

And the takeaway is this: Intermediate TIPS look to have the benefit of shortening duration from a broader TIPS allocation without giving up a substantial amount of breakeven exposure that would result from using the current short duration offerings.


Founded in 1993, Stadion Money Management is a privately owned money management firm based near Athens, Georgia. Via its unique approach and suite of nontraditional strategies with a defensive bias, Stadion seeks to help investors—through advisors or retirement plans—protect and grow their “serious money.” Contact Stadion at (800) 222-7636 or www.stadionmoney.com.

References to specific securities or market indexes are not intended as specific investment advice.

 

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