McCall’s Call: Bracing For Inflation With ETFs

October 13, 2010

All aboard! The inflation train is leaving the station, but it’s not too late to jump on it with a number of ETFs.

Speculation that the Federal Reserve will announce a new round of quantitative easing has increased over the last two weeks and investors are convinced enough that it will happen to put their money on the line.

Matthew D. McCallBig money has been flowing into Treasury inflation-protected securities (TIPs) as investors anticipate the next round of so-called QE will lead to higher inflation in the years ahead. The inflation concern is based on the belief that to pay for the Fed’s purchases, the government must print more money.

To prove my point about inflation expectations you can turn to the breakeven rates, which measure the spread between conventional bond yields and the yields on the TIPs. Last week the spread rose to 193 basis points based on the 10-year Treasury note, the largest since June and well above 147 basis points in August. The number suggests investors are pricing in an inflation rate of 1.93 percent within a decade.

The 10-year breakeven rate is almost back to its five-year average of 210 basis points, but well off the year high of 249 basis points in January. Because it’s clear the Fed isn’t concerned about inflation, inflation-protection-related investments should continue to outperform. My belief, which I share with a lot of people, is based on a view that Bernanke wants inflation above the 1.5 percent to 2 percent target.

If you still need more evidence that inflation is a concern in the future, I present you with the iShares Barclays TIPS Bond ETF (NYSEArca: TIP). The ETF invests in a variety of TIPs with an average maturity of 9.3 years and currently has an SEC 30-day yield of 0.35 percent. Year-to-date the ETF is up 7.5 percent and is close to breaking above the 2008 high. TIP has an expense ratio of 0.20 percent.

In September 2009 Pimco launched three ETFs that tackle the TIPs market. The Pimco Broad US TIPS ETF (NYSEArca: TIPZ) is similar to TIP with an average maturity of 9.1 years, an SEC 30-day yield of 1.6 percent, and 0.2 percent expense ratio. This Pimco ETF is up 8.3 percent in 2010.

PIMCO offers investors exposure to more concentrated TIP ETFs through the Pimco 1-5 Year US TIPS ETF (NYSEArca: STPZ) and the Pimco 15+ Year US TIPS ETF (NYSEArca: LTPZ). As the name implies, STPZ invests in TIPs with maturities between one and five years. The average maturity is 3.0 years and the SEC 30-day yield is 1.55 percent. The shorter the maturities, the lower the volatility and therefore the gains/losses will be muted compared to a bond ETF with longer maturities. Year-to-date the ETF is only up 3 percent.

On the other end of the spectrum is LTPZ, which has an average maturity of 23.0 years and has risen 13.5 percent in 2010. The SEC 30-day yield is slightly higher at 2.0 percent. Both ETFs have expense ratios of 0.2 percent.

Investors that believe the Fed will come in with more quantitative easing and keep interest rates artificially low and at the same time set the economy up for inflation should lean toward LTPZ. However, keep in mind that if the Treasury bubble bursts it would have a larger effect on LTPZ and the price of the ETF could fall sharply.

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