Runaway Inflation: Do TIPS Really Help?

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Includes: CUT, DJP, GLD, GSP, IPE, TIP
by: IndexUniverse

By Murray Coleman

With the latest consumer price index showing its biggest leap in 17 years, economic signals seem to bode well for investors of Treasury Inflation-Protected Securities. After all, when prices shoot up, isn't that the time to hold TIPS?

Consider what they're supposed to do for a portfolio. TIPS are designed to offer protection against rises in the Consumer Price Index. Twice a year, the par value of the TIPS bond is adjusted upward at a rate tied to the CPI. The higher the index, the more a TIPS value will be raised.

But in order to compensate for this upward adjustment and inflation protection, TIPS typically pay a lower interest rate than conventional, or nominal, Treasuries.

As of mid-day Thursday, for instance, a 10-year Treasury note was yielding 3.89%; a similar-termed TIPS bond was yielding some 1.66%. The difference between the two, 2.33%, is referred to as the TIPS' break-even spread. It reflects what the market expects inflation to be over the next 10 years.

There are exchange-traded funds tracking TIPS, and those funds show a similar pattern. For example, the iShares Lehman TIPS Bond Fund (NYSE: TIP) had a 30-day SEC yield of 1.36% through Wednesday. By contrast, the iShares Lehman 7-10 Years Treasury (NYSE Arca: IEF) had a yield of 3.86%. From that view, the break-even inflation for a TIPS position would be slightly higher at 2.5%.

Stark Contrasts

But either way, on a single-issue basis or comparing broad bond portfolios, the differences are stark to the latest government figures. The July CPI reading said inflation had risen 5.6% since the same period a year ago, more than double TIPS' break-even spread. By that measure, TIPS would appear to be an attractive bargain.

The rub is that questions about the CPI's accuracy in accounting for the full impact of rising prices make the value of TIPS funds less clear, say analysts.

The CPI rate has been bouncing around of late, driven by wide swings in energy prices. Moreover, many believe that the complicated methodology behind the CPI deliberately understates the true level of inflation through techniques like hedonic regression (which adjusts down the imputed cost of goods as the quality rises) and substitution (the idea that consumers will happily substitute one good for another if prices rise too much).

"The crime here is that people think they can protect themselves against inflation by investing in a bond that increases its principal by a flawed inflation gage like the CPI," said Michael Pinto, senior market strategist at Delta Global Advisors.

Joe Clark, a demographics expert and managing partner at the Financial Enhancement Group, agrees. "The signs we're seeing in the TIPS market right now are very conflicting," said the Anderson, Ind.-based advisor. "Prior to this latest report on Thursday, the PPI (Producers Price Index) had been running hot while the CPI hadn't been going up much at all."

That meant companies had been reporting higher raw materials prices but not passing those higher costs along to consumers. "But now that the CPI has really jumped, inflation is bound to receive more attention from both consumers and investors," Clark said.

And he doubts that July's CPI reading will be a one-month phenomenon. But such inflation concerns are likely to be tempered somewhat over time, he added. "While some goods and services are clearly going to be more expensive, others are clearly going to be cheaper," Clark said.

Even though investors should expect inflation to rise, he says "it doesn't appear to be one of massive hyper-inflation that would most benefit an ETF" like the iShares Treasury Inflation-Protected Securities Fund (NYSEArca: TIP).

As a result, Clark's in no hurry to jump into TIPS right now, preferring other forms of high-quality bonds. But he's sticking with existing positions for clients in TIPS funds, particularly inflation-protected certificates of deposits. "They work much like a TIPs fund. But a CD will protect your principal as well, which is appealing to more conservative investors interested in holding TIPS as part of their long-term allocation strategy," Clark said.

Ben Jacoby, a founder of Brinton Eaton Wealth Advisors, believes that at least some TIPS deserve to be in long-term investors' portfolios.

"But they offer only marginal protection," said the Morristown, N.J.-based advisor. "There are more direct and efficient ways to hedge against inflation."

Inflation-Hedging Tools

Choosing some good commodities funds is probably a stronger option than just relying on TIPS, Jacobs says. For his clients, he uses the iPath S&P GSCI Total Return ETN (NYSE: GSP). "It's an ETN (exchange-traded note) so it guarantees you the return of the underlying index," Jacoby said. "And GSP has lower expenses than actively managed mutual funds."

He warns that the ETN's index is very aggressive with almost two-thirds of its underlying components in energy. For more conservative investors, Jacoby suggests iPath Dow Jones-AIG Commodity Index ETN (NYSE: DJP). "It follows a broad index with no more than any one commodity being 33%," he said. "So it tends to be less volatile than GSP."

He's also investing in the Claymore/Clear Global Timber ETF (AMEX: CUT). "What we like about timber is that even if the economy isn't doing well, you don't have to harvest the field," Jacoby said. "Also, everything you invest in will probably be counted as long-term capital gains, which is another advantage to timber."

Strategist Pinto likes gold as the best hedge against inflation right now. That's even though it has undergone a double-digit correction. Since its 52-week peak in late March, the price of SPDR Gold Shares (NYSE: GLD) has dropped about 20%.

"This would be a wonderful time for investors who were afraid to buy a gold fund when it was at $1,000 an ounce to start wading back into the market," Pinto said.

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