When it comes to fighting inflation with TIPS, it helps to know all the tools you have at your disposal.
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 is by Rusty Vanneman, chief investment officer of Omaha, Neb.-based CLS Investments and is co-authored by Josh Jenkins, CLS Investment research analyst.
Despite the daily chatter regarding the Federal Reserve and what it might do and when, there are many ways investors can actively manage their bond portfolios above and beyond attempts to time the Fed’s actions.
One such opportunity involves taking advantage of the inherent seasonality of inflation expectations to rotate between nominal Treasurys and Treasury inflation-protected securities (TIPS).
And there are plenty of options, from one of the oldest and biggest TIPS in the space, the iShares TIPS Bond ETF (TIP | A-99) or more newfangled approaches to tackling inflation through TIPS, such as the use of an internationally focused fund like the PIMCO Global Advantage Inflation-Linked Bond Exchange-Traded ETF (ILB | C).
But first, let’s look more closely at TIPS and how they work.
Very Brief History Of TIPS
TIPS are increasingly becoming the “risk-free asset” of choice among many asset allocators, as they become a key part of many strategic allocations. TIPS were first issued by the U.S. Treasury in 1997, and by the early 2000s, more than $200 billion worth of the securities had entered the market.
Like Treasurys, TIPS pay a fixed rate on the bond’s principal value. Unlike nominal Treasurys, however, the principal amount is adjusted by inflation, as measured by the nonseasonally adjusted Consumer Price Index for all Urban Consumers. This means that TIPS deal in a “real” (i.e., inflation-adjusted) fixed-rate framework, while nominal Treasurys do not, leaving the latter vulnerable to inflation.
Breakeven Inflation Rate
How can investors decide to alter their holdings in TIPS and nominal Treasurys? One way is to calculate the rate of inflation where an investor holding TIPS would break even with an investor holding Treasurys. This can be approximated by:
Breakeven inflation rate = (1 + Treasury nominal yield) / (1 + TIPS real yield) -1
When evaluating which exposure to take, you can simply compare your inflation expectations versus the market’s by using the breakeven inflation rate as a proxy for the market’s expectation. For example, if the breakeven was at 2.0 percent, and you expected inflation to be higher, you would purchase the TIPS. If you expected inflation to be lower than 2.0 percent, you would want the nominal Treasury.