ETFs Treatment Of Phantom Income
There are two components to the yield of a TIPS bond: the interest and the inflation adjustment. As the principal value of TIPS bonds is adjusted according to the level of recorded inflation, the interest paid by a TIPS bond will increase or decrease. This is because the coupon rate paid by the TIPS bond is fixed, but that coupon rate is applied to a changing principal value of TIPS bonds.
For TIPS bonds held outside of qualified accounts, IRS rules require that taxes be paid on the “phantom income” each year. The amount of phantom income is the increase in principal value of the TIPS bond due to the inflation adjustment.
For some investors, this calculation can be daunting. Additionally, phantom income creates a mismatch between when an investor is taxed and when they are paid. Phantom income is assessed each year, even though an investor does not receive their adjusted principal amount until the TIPS bond matures.
ETFs help to simplify things by including the phantom income in the overall income of the ETF, so an investor receives their income in the same year that they are taxed.
This treatment is one of many reasons why investors may prefer to own TIPS exposure through an ETF, as opposed to purchasing individual bonds. However, the maturity nature of individual bonds would be a reason investors may instead prefer to purchase individual bonds.
Recent TIPS Performance Has Been Poor
While TIPS outperformed nominal Treasurys for much of last decade as realized inflation exceeded expectations, they have underperformed in the past few years. Ultimately, realized inflation below expectations has driven recent underperformance.
The following chart shows TIP compared with the iShares 7-10 Year Treasury Bond (IEF | A-55).
The Current Case For TIPS
Given the fact that realized inflation will not always match expected inflation, we expect there will be periods in the future where TIPS will outperform nominal Treasurys. Since we feel the likelihood of correctly forecasting short-term inflation is low, we would advocate for strategic investors to maintain some exposure to TIPS bonds in a well-diversified fixed-income allocation.
If an investor wished to speculate that realized inflation will be below expected inflation over the next 10 years by investing solely in nominal 10-year Treasurys, it would be similar to picking who will win more games between the Cavaliers and the Warriors over the next 10 years. However, that bet would be based on today’s market environment.
With inflation rates historically low, the opportunity for inflation to surprise on the upside may outweigh the risks on the other side. With inflation rates near 2%, there is only 2% down to get to 0%. However, the risk on the upside could be near 8%, if inflation rates were to near 10% in the future.
While we believe inflation rates will remain low in the intermediate term, we are not ignoring the risk that the underdog may win some games, and the underdog may be the favorite five years from now.
So, remember to “mind the gap” and account for the whole spectrum of potential scenarios when deciding whether to include TIPS in a well-diversified portfolio to complement exposure to nominal Treasurys.
TIP, TDTT, IEF and STPZ have been, may be and/or are currently held in several TOPS Portfolios. ValMark Advisers Inc. is the manager of the TOPS Portfolios of ETFs. ValMark started managing "TOPS" separately managed accounts of ETFs in 2002. The firm manages more than $5.1 billion in ETFs for retail and institutional clients in multiple investment products. Email: [email protected]; phone: 800-765-5201. For a complete list of relevant disclosures, please click here.