Seeking Alpha

A 'TIP' For You Bond Investors

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Includes: SCHP, TDTF, TIP
by: Michael A. Gayed, CFA
Summary

The spread between the 10year and 2year Treasury bond inverted this summer but is slowly turning positive again.

One area of the bond market that is being overlooked is TIPS (Treasury Inflation Protection Securities).

TIPS should be the better bet over traditional Treasury bonds. Schwab offers the best value for the product and investors looking to rotate out of longer-dated Treasuries can find some.

“What goes up must come down.” – Sir Isaac Newton

The US Treasury market is becoming one of the most overbought sectors of the investment spectrum. They are some of the only bonds in the world that offer investors at least a small amount of income. As discussed in the most recent Lead-Lag Report, inflation is expected to rise which will lead to a correction in Treasuries and ultimately a steepening of the yield curve.

The spread between the 10year and 2year Treasury bond inverted this summer but is slowly turning positive again. One area of the bond market that is being overlooked is TIPS (Treasury Inflation Protection Securities). These bonds have a set yield when they are issued, but the principal amount is adjusted upward and downward based on inflation (measured by the Consumer Price Index). As you can see, US CPI has started to move upwards and should continue as the Federal Reserve stokes the fire with lower interest rates.

Investors can buy TIPS directly from the US Treasury, or another good alternative is the many ETFs available. In order to take full advantage of a steepening yield curve, the ETFs that focus on the intermediate-term part of the market are best. Three such funds are the iShares TIPS Bond ETF (TIP), Schwab U.S. TIPS ETF (SCHP), and Flexshares iBoxx 5yr Target Duration TIPS ETF (TDTF).

All three funds own a portfolio of TIPS across the duration-spectrum. Flexshares is the only fund of the three that has a target duration of 5 years. Currently, iShares and Schwab both have a duration of about 7.5 years. They invest in longer-dated TIPS. This also lends a higher yield to these two funds compared to TDTF. In order to get an extra 10 basis points of yield, the longer duration subjects the funds to more interest rate sensitivity. This can be seen in their maximum drawdown. Over the past 3 years, TDTF has had a maximum drawdown of -2.12% compared to -2.53% and -2.48% for TIP and SCHP. Schwab by far has the lowest expense ratio, and when your yield is less than 2%, every basis point of savings in expense helps the total return.

Category

iShares TIPS

Schwab US TIPS

FlexShares 5yr Target Duration TIPS

TIP

SCHP

TDTF

Yield

1.85%

1.86%

1.74%

Expense Ratio

0.19%

0.05%

0.18%

Duration

7.3

7.48

4.77

Maximum Drawdown

-2.53%

2.48%

-2.12%

In the Lead-Lag Report scenario of increasing inflation and a steepening yield curve, TIPS should be the better bet over traditional Treasury bonds. Schwab offers the best value for the product and investors looking to rotate out of longer-dated Treasuries can find some inflation protection in SCHP.

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