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:
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.
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.