TIPS: A Poor Inflation Hedge Today

by: The ETF Authority

Amidst a flood of government stimulus and the corresponding expansion in monetary supply, many investors are actively seeking to protect their savings from the ravages of inflation. Many have turned to Treasury Inflation-Protected Securities or TIPS. TIPS are government debt instruments that like nominal bonds pay a stated coupon expressed as a percentage of principal.

However, unlike nominal bonds, the principal value adjusts based on changes in the Non-Seasonally Adjusted Urban Consumer Price Index (CPI-U), which is a weighted basket of typical consumer expenditures. The amount of the coupon payment may rise in conjunction with observed inflation as measured by the CPI-U.

Proponents of the CPI-U and by extension TIPS often cite that the index includes the impact of "volatile" food and energy costs which the headline core-CPI omits. However, the broad food component represents just under 15% of the index and motor fuel weighs in at just 5%. Instead, it is the chronically depressed housing component that steers the index today, accounting for over 40%. This weighting structure serves to mute the impact of rising food and energy costs as the housing sector remains weak.

As the positive contribution of energy and food inflation to principal value appears limited, we must next consider the impact of interest rates. When inflationary expectations prevail, a rational investor will demand a greater inflation risk premium as compensation. This risk premium is embedded in the interest rate associated with new issuance of bonds. When higher yielding issues come to market, comparable issues yielding lower rates are viewed less favorably by the secondary market and experience price declines.

The metric which seeks to gauge the impact of rising rates on the value of debt securities is duration. As a rule of thumb, duration provides a rough estimate of the decline in market value given a broad 1% increase in interest rates, all other things being equal. Using the effective duration of the popular ETF (NYSEARCA:TIP) as an example, if we woke up tomorrow with U.S. interest rates broadly higher by 1%, the market value of the underlying securities would decline 3.73%.

In theory, a corresponding increase in CPI-U (less the minimal income generated) would be necessary for an investor in TIP to breakeven.

While the low correlation thesis is somewhat supportive of TIPS, they are not likely to serve as meaningful hedge against inflation in the current environment. Due to significant exposure to housing in the underlying index and exposure to the downside of rising rates, TIPS may prove a breakeven proposition at best.


Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.