Time To Skip The TIPS? 4 ETF Strategies For Every Inflation Outlook

 |  Includes: GTIP, ITIP, STIP, TIP
by: Matt Tucker, CFA

A year ago, I wrote a blog post about an interesting phenomenon in the Treasury Inflation Protected Securities (OTC:TIPS) market. Despite negative yields on TIPS at the time, investors were pouring into the securities. It seemed that people were so concerned about inflation, they were seeking protection against it without much regard for the cost of that protection.

If investor demand for TIPS is a good indicator of inflation fears, then the story today is that those fears are – at least temporarily – on hold. Once again, TIPS are sporting a negative yield, but this time it’s causing many investors to shy away from the category. So far in 2013, TIPS ETFs have seen -$364mn in net outflows globally, enough to cause more than a few calls from clients into my team.

So what’s a TIPS holder to do? First and foremost, it’s important to have an opinion about the potential for rising inflation. Here are a few strategies to consider, depending on your view:

  1. Stay in TIPS. Although investors are earning negative real yields and are exposed to relatively long duration (the iShares TIPS ETF, TIP, currently has a duration of 8.2), TIPS are the only securities designed to provide direct protection against higher than expected inflation. And while many investors may not like the interest rate risk in TIPS, it is this characteristic that can yield positive returns if real rates suddenly increase.
  2. Reduce TIPS duration. Investors looking to maintain direct inflation protection but potentially reduce interest rate risk may consider adding or moving to short-term TIPS, like the bonds included in the iShares 0-5 Year TIPS Bond ETF (NYSEARCA:STIP). Inflation adjustment is the same across all TIPS, but choosing shorter maturity TIPS can lower the duration considerably – STIP currently has a duration of 2.6. However, this lower duration often comes at a price in the form of lower yield (STIP’s current real yield to maturity is -1.14%, versus TIP at -0.86%). Lower duration also means that short-term TIPS would likely underperform TIPS in a falling real yield environment.
  3. Diversify with international TIPS. Some people don’t realize that inflation-protected securities are issued in many countries outside of the US. Thanks to the proliferation of ETFs dedicated to this space (such as the iShares Global Inflation-Linked Bond ETF, or GTIP, and the iShares International Inflation-Linked Bond ETF, or ITIP), investors can now get exposure to this segment, which was previously somewhat difficult to access. Diversifying across non-USD bonds from developed and emerging sovereign issuers can give investors exposure not only to inflation-protection, but also different currencies, local rates and credit spreads. Interestingly enough, both GTIP and ITIP currently offer positive real yields, albeit with longer durations than TIP.
  4. Move to credit bonds. For those who are less concerned about inflation, the answer may be to skip TIPS altogether. This approach would obviously give up the explicit inflation protection offered by TIPS, but by adding exposure to credit spreads, investors can increase yield (for a given duration). And if a strengthening economy pushes rates higher with contained inflation, credit could potentially outperform TIPS on a total return basis. Conversely, a stagflationary environment (rising inflation coupled with a weak economy) would likely be punishing to credit and beneficial to TIPS.

The good news: No matter what your outlook on inflation, ETFs can be great tools to help you express that view.

Sources: Bloomberg, BlackRock

Matt Tucker, CFA, is the iShares Head of Fixed Income Strategy and a regular contributor to the iShares Blog. You can find more of his posts here. The performance quoted represents past performance and does not guarantee future results. Investment return and principal value of an investment will fluctuate so that an investor’s shares, when sold or redeemed, may be worth more or less than the original cost. Current performance may be lower or higher than the performance quoted. Performance data current to the most recent month end may be obtained by calling toll-free 1-800-iShares (1-800-474-2737) or by visiting www.iShares.com. Click the following tickers for the Funds’ SEC 30-day yield: STIP, TIP.

Bonds and bond funds will decrease in value as interest rates rise and are subject to credit risk, which refers to the possibility that the debt issuers may not be able to make principal and interest payments or may have their debt downgraded by ratings agencies. TIPS can provide investors a hedge against inflation, as the inflation adjustment feature helps preserve the purchasing power of the investment. Because of this inflation adjustment feature, inflation protected bonds typically have lower yields than conventional fixed rate bonds and will likely decline in price during periods of deflation, which could result in losses. Government backing applies only to government issued securities, not iShares exchange traded funds.

In addition to the normal risks associated with investing, international investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Diversification may not protect against market risk.

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