TIP ETF: A High Dividend Stock and Inflation Hedge?

1. MARKET OVERVIEW

Since the vast majority of stock prices move in synch with the major indices, we must evaluate any new investing in the context of the overall market’s direction.

A. MARKET STATUS

Confirmed, though decelerating downtrend, still seeking a bottom.

IMPLICATIONS FOR INCOME STOCK INVESTORS

Invest in income stocks only with funds not needed for the next number of years. Invest only in companies with prospering businesses that can sustain their high dividends. These are the stocks I covered in this blog. As long as we continue to get great returns in at least the 7% - 10% range with capital reserved for investment, we can relax about the vicissitudes of stock prices

B. DISCUSSION

Despite the optimism accompanying the new US administration, the current picture obviously remains bleak.

• The financial system remains in critical condition, though it may stabilize if central bank life support systems continue to function.
• The housing crisis appears likely to worsen as a wave of defaults approach in 2009.
• Layoffs are occurring by the thousands.
• Consumers are continuing to reduce spending.
• Various key infrastructures (utility, transportation, energy, health care, to name a few) need major investment after years of neglect.

The House of Representative’s version of the stimulus bill appears unlikely to work. In sum:

• It does little to improve investment in the productive assets and new technologies that will generate future jobs and wealth in the US. The bill needs much heavier emphasis on tax credits for business investment. If you buy a capital asset (computer, truck, software package, etc.) you get $5000 off your tax bill, or you can just pay that $5000 in taxes. Most business owners would rather get something for their money instead of paying it away in taxes. That gets orders up and people hired and doing productive work.
• Improvements in roads and other infrastructure, while necessary, provide temporary jobs and stimulus, but very little direct impact on long term growth. A new road doesn’t cause another new road to be built, though easing traffic in theory speeds transportation and perhaps lowers shipping costs, etc.
• Tax breaks and credits to low and middle income workers essentially just transfers wealth from those who create it to those who don’t, and who may or may not create additional stimulus through their spending. Tax credits for those who may now owe any tax anyway are just glorified welfare.

Let’s hope the Senate can make some meaningful improvements, or things are getting bleaker still.

2. A HIGH-DIVIDEND STOCK AND INFLATION HEDGE? ISHARES BARCLAYS TIPS BOND ETF (TIP)

Treasury Inflation-Protected Securities (TIPS) are marketable securities whose principle rises or falls with the Consumer Price Index. In theory they’re among the ultimate conservative income investments. They not only provide the safety of treasury instruments, they also protect investors against inflation.

For a those interested in some background on these, see here.

Recently there have been a number of recommendations for investments like this. The basic, simplified theory behind them is:

• The US prints more money to pay for the various bailout and stimulus packages.
• These programs work at least well enough to prevent financial collapse and resulting deflation.
• The overabundance of dollars causes inflation.

Thus those seeking a conservative inflation hedge with some income should consider this variation on TIPS.

As a service to my readers, a brief summary of the pros and cons is in order.

A. WHAT

A member of the iShares Trust fund family, this ETF seeks to match the performance of the inflation-protected sector of the US Treasury market as defined by the Barclays Capital U.S. TIPS Index. For more on its basics, see its profile here.

B. WHY

Interest rates are unlikely to go much lower, with 10 year Treasuries at about 2.5%.

Interest rates should increase over the coming year as the US sells bonds (i.e. prints money) to pay for the trillions in bailouts, causing inflation, a drop in the dollar, and ultimately a rise in interest rates.

As rates rise, foreign buyers drive up demand for Treasuries, especially those with some inflation protection for added yield.

When credit markets are very nervous and deflation fears overcome inflation worries, as 10/08 and 11/08, TIP yielded over 9%. As sentiment has reversed, prices for TIP have climbed and the yield as a bit over 6% (based on the assumption that its $0.80 monthly dividend continues).

In sum, solid dividend and good potential for capital appreciation.

C. WHY NOT

The fund has in fact not paid a dividend since October and it’s unclear when it will resume and at what level. Thus yield is in fact uncertain.

The US Government’s CPI consistently underestimates inflation, so the TIPs are at best a partial protection.

While credit has loosened somewhat recently, there is still lots of fear and Treasuries have been bid up as investors flee to quality. Treasuries are questionable bargains at these levels.

Certain commodity-based investments, especially energy, arguably offer better appreciation (and hence inflation protection) potential given the current level of energy and other key commodity prices.

D. CONCLUSION

At best, TIP is an income producing inflation hedge of uncertain yield for those seeking to diversify a portion of their portfolio into bonds. However, there are investments available with better risk/reward ratios, like the best of the energy infrastructure MLP, power utilities, and certain Canadian Royalty Trusts. They hold or are linked to underpriced hard assets, and their yields are higher and more reliable, and they have better prospects for long term appreciation.

In sum, don’t overload on TIP and variations on this theme. Despite the hype, there are better opportunities unless you specifically seek TIPS exposure for some conservative diversification.

Disclosure: The author does not own TIP.

Comments

[puttster:]

You say the good reason to buy TIP is because interest rates are going up? Worst logic I have seen today.

Jan 28 05:20 PM

[jahowle:]

puttster: It could be a good reason, the logic is that if interest rates are up it is because of a rise in inflation. The 2 do not necassarily move in tandem. When you buy a TIP bond you are simply locking in a 'real rate of return' over and above an expected positive inflation rate. If inflation goes negative you can earn no interest but the Treasury will pay you back par value. Be warned that the older TIPs bonds have accrued inflation factors and that value can go down. Be careful out there.

JAH

Jan 28 05:36 PM

[Prudent Man...:]

When did TIP declare its last dividend? I talked with Barclays and they told me they passed. Also, the TIPs themselves are illiquid assets and there are opportunities for the "Authorized Agent", that person Barclay's did know anything about, can manipulate the price.

Be very, very careful with Fixed Income ETFs, or any ETF, that consist of illiquid securities.

I suggest that Mr. Wachtel limits his opinions to subjects with which he has knowledge, which certainly is not TIPs. Who allowed this to be printed?

Jan 28 05:55 PM

[RiskTrade:]

JAH,
As you say TIPS have an inflation factor determined by the MoM CPI figure. This factor is used to adjust the principal upward upon which the stated coupon is calculated thereby leading to coupon income that is indexed to inflation. Hence TIPS keep their value when inflation occurs as the numerator (i.e the indexed coupon cash flows) increases when inflation occurs. However that is only the numerator element of a TIP. The denominator is the interest rate at which you discount cash flows (i.e the respective nominal treasury rate) Hence as the central bank increases interest rates in order to reduce inflation the PV of each coupon payment and the final payment at maturity decreases. This is basically encaspulated in the TIPS interest rate duration. Hence when interest rates rise TIPS will decline in value if the effect of the indexed coupon does not offset the increase in the nominal rate. As TIPS have positive duration both in response to a parrallel shift in real yields and nominal yields they will decline in price if interest rates increase significantly.





On Jan 28 05:36 PM jhowle wrote:

> puttster: It could be a good reason, the logic is that if interest
> rates are up it is because of a rise in inflation. The 2 do not necassarily
> move in tandem. When you buy a TIP bond you are simply locking in
> a 'real rate of return' over and above an expected positive inflation
> rate. If inflation goes negative you can earn no interest but the
> Treasury will pay you back par value. Be warned that the older TIPs
> bonds have accrued inflation factors and that value can go down.
> Be careful out there.
>
> JAH

Jan 29 04:58 AM

[donzelion:]

Seems to me that the argument for TIPs is either

(1) a gamble that the increase in interest rates that may lurk ahead will be substantially smaller than the increase in CPI. For example, if interest rates go up by 1% (causing TIPs to drop by X%), but CPI goes up by 5% (so that, within Y period of time, I've recovered the money lost by the increased interest rate), then I come out ahead with TIPs. OR

(2) a gamble that persistent deflation may lurk ahead, which will substantially increase the value of cash stored now. As a deflation hedge, TIPs should work fine, although there may be better alternatives.

Both of these stories are plausible to some extent, though as an inflation hedge, TIPs certainly seem less promising than alternatives (commodities). They won't work unless the Fed refrains from raising interest rates in response to rising CPIs - that might happen if the Fed were asleep (for months or years), or if they made a conscious choice to devalue the dollar by increasing the money supply. Likelihood? Pretty slim.

Hence: I think TIPs deserve a small allocation, since there are (barely) plausible scenarios where they work out, but only a sprinkling - no more than 5%.

Jan 29 11:38 AM

[d_teller:]

The ETF "TIP", last dividend payment was back in Oct.08. They used to pay monthly, but their "NAV" or market price has had a greater recent volatility. I'd look at a chart, and at a site that has accurate info regarding their intentions to pay dividends, and when. Such a site is not at Seeking Alpha.

Jan 29 08:59 PM

[Toby:]

Anyone know when TIP will pay its next dividend?

Mar 23 10:22 AM