‘Mind The Gap’ In TIPS

March 01, 2016

This article is part of a regular series of thought leadership pieces from some of the more influential ETF asset managers in the money management industry. Today's article is by Michael McClary, chief investment officer of Akron, Ohio-based ValMark Advisers, which markets the “TOPS” brand of asset allocation models.

Anyone who has had the opportunity to visit London would recognize the phrase “mind the gap.” When riding the subway system in London, a recording plays at each stop, reminding riders to “mind the gap,” or carefully exit the train noting the distance between the train door and the station platform.

This reminder can be helpful in many aspects of life. Many decisions require us to allow for a spread, instead of black/white or yes/no. For example, flipping a coin does not involve factoring in a spread: It will land on heads or tails. However, placing a wager on the Cleveland Cavaliers to beat the Golden State Warriors does typically involve a spread decision. Likewise, spreads typically change over time.

When investing in TIPS bonds, it is important to “mind the gap.” Don’t lose site of the TIPS spread.

TIPS Provide Choice For Treasury Investors

With the advent of Treasury inflation-protected securities (TIPS) in 1997, investors in U.S. Treasurys were given the choice of investing in nominal Treasury securities or TIPS. TIPS bonds pay a lower stated interest rate, yet include an adjustment in principal value tied to inflation.

To help investors decide which choice is the right one for them, the TIPS spread was developed.

The TIPS spread is the difference in yield between TIPS and nominal Treasurys of corresponding maturities. This spread is often used as a gauge of predicted future inflation levels. For example, if the 10-year TIPS spread is 2%, that would mean the markets expect the inflation rate to be 2% over the next 10 years.

Today portfolio managers like us monitor the TIPS spread as a valuable tool in making portfolio decisions.

The following chart shows the five-year TIPS spread versus actual inflation back to 2002. The chart shows both the volatility of the spread and the meaningful disconnect between expected and realized numbers:

Why TIPS?

We feel TIPS bonds can be a valuable diversification tool for strategic investors. In periods where realized inflation exceeds expected inflation, TIPS bonds generally outperform nominal Treasurys. Likewise, TIPS should do well in periods of high inflation while other popular asset classes may struggle.

While gold has developed a reputation as a valuable asset in periods of high inflation, we feel other risks involved in gold assets might outweigh the specific inflation benefit. Obviously, speculators may decide to invest in gold for other reasons beyond the potential inflation benefits.

How Do I Invest?

While investors can purchase individual TIPS bonds, many investors choose to gain exposure to TIPS through ETFs instead.

Having managed ETF portfolios since 2002, we were one of the first adopters of the iShares TIPS Bond ETF (TIP | A-99). TIP was the first ETF to provide targeted exposure to the TIPS market. Over the years, we have seen choices develop.

Now, we have tools to adjust duration targets of TIPS, such as the FlexShares iBoxx 3-Year Target Duration TIPS Index Fund (TDTT | B-48) and the PIMCO 1-5 Year U.S. TIPS Index ETF (STPZ | A-74). Likewise, TIPS bonds are held in several other diversified ETFs and mutual funds.

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