ETF TIPS Can Help Protect Against Unexpected Changes in Inflation

Mencionado: PIMCO 1-5 Tahun US TIPS Index ETF (STPZ) , PIMCO 15+ Tahun US  TIPS ETF (LTPZ) , Schwab US TIPS  ETF (SCHP)  , Vanguard Short-Term Infl-Prot Secs ETF™ (  VTIP)

Funds that follow the Bloomberg Barclays Aggregate Bond Index (“the Agg”) can become large holdings of core bonds. Broad and conservative, the fund offers investors exposure to an investment-grade bond market area broad enough to effectively diversify the issuer’s sectors and risks, and conservative enough to serve as a ballast for stock allocations.

While inflation risk is cited in yields on every fixed income security contained in Agg, that doesn’t mean the price is right. Realized inflation may exceed expected inflation. Unforeseen inflation is hurting bond investors.

Inflation-protected treasuries can protect investors from the unforeseen adverse effects of inflation. This article will discuss the complexity of the TIPS market and the benefits of indexing TIPS exposure. I conclude by highlighting some of the best TIPS of exchange-traded funds in the market.

As the
name implies, TIPS provides a level of protection against inflation, in the form of regular adjustments to reflect the observed inflation, thus protecting against unforeseen inflation. These bonds are issued by the US Treasury Department over a period of five, 10, and 30 years. Since they are issued by the Ministry of Finance, they present the same amount of credit risk as nominal Treasuries (not adjusted for inflation). As of January 2020, there were 44 different TIPS bonds with a total face value outstanding of approximately $1.5 trillion.

When considering tips for portfolios, it is important to remember that inflation risks are already taken into account in the price of nominal Treasury bonds. Therefore, TIPS is more favorable when the realized inflation exceeds the expected inflation.

The equilibrium inflation rate represents the spread between the yield on nominal Treasury bonds and TIPS bonds of the same maturity. This is a useful metric for measuring the difference between expected and realized inflation. But Treasuries carry inflation risks, which are factored into their yields through a premium that moves interest rates off its theoretical equilibrium. Thus, this propagation is just a proxy.

In addition, in a 2016 letter, the Federal Reserve Board noted that there is greater liquidity in the nominal Treasury bond market than in the TIPS market. As a result, TIPS returns also include liquidity premiums to compensate for the fact that they are relatively less liquid [1]. This drives TIPS performance higher than it should. Nonetheless, as my colleague Maciej Kowara discussed in his 2017 article on TIPS, the recording of this measure of equilibrium inflation has been a good, albeit inaccurate, predictor of future inflation rates [2].

The conclusion is that the price of TIPS is influenced by factors other than inflation. Although this can affect the extent to which they protect against unexpected changes in inflation, it does not necessarily render them useless. For example, according to data from Morningstar Direct, there were three calendar years from 2008 to 2019 in which the annual CPI rate doubled. Figure 1 shows that the short-term TIPS index outperformed the short-term Treasury bond index and inflation in each of these years.


  • Our TIPS for inflation protection

In addition, there have been five calendar years since 2008 in which the inflation rate exceeded 2%. In each of those years, the TIPS index outperformed similar maturing Treasury indices, as shown in Figure 2.

The benefits of indexing TIPS
Market TIPS are large and uniform. It consists exclusively of debts issued by the US Treasury. These securities are virtually free of credit risk and are often traded, which means price discovery is always on the move. These factors make the TIPS market conducive to indexing, as the set of opportunities lacks the necessary breadth and inefficiency that makes it a richer set of opportunities for active strategies. Low-cost index funds are a hard-to-beat bogy for managers active in this segment of the fixed income market.

When it comes to
choosing from the ETF’s TIPS menu, the index methodology should be at the top of the investor’s due diligence checklist, as is always the case when it comes to index fund selection. In the case of index TIPS funds, the options are relatively straightforward, as all these funds are based on the same relatively homogeneous pool of bonds. There are no sectoral or credit quality criteria to consider. In addition, while different TIPS indices have different liquidity thresholds, the size of the TIPS issuance makes those options largely irrelevant. The smallest TIPS bond as of January 2020 (CUSIP 912810FQ) has a face value of more than $7 billion, which is higher than the minimum threshold for any TIPS index currently tracked by the ETF.

The main differentiator between TIPS ETFs is the maturity range included in the underlying index. Therefore, the first option investors face is between short, medium, and long-term exposures. For example, in January 2020, the average effective duration for the Pimco 1-5 Year US TIPS ETF (STPZ), which tracks the Ice Bank of America 1-5 Year US Inflation Linked Treasury Index, was about three years. Meanwhile, the average effective duration of the Pimco 15+ Years US TIPS ETF (LTPZ), which tracks Bank of America’s ICE index of 15+ Years, is approximately 22 years.

Since the key factor in choosing a TIPS ETF is the desired maturity band, it is important to understand how well the TIPS in this band protect against inflation.

Figure 3 below shows the correlation between monthly changes in CPI and monthly performance of the TIPS index in the short, medium and long term. In all three periods, the Ice Bank of America 1-5 Year US Inflation Linked Treasury Index showed the strongest correlation with changes in CPI.

Longer-duration TIPS are less sensitive to CPI fluctuations, largely because they are more sensitive to changes in nominal interest rates. Interest rate risk also explains why short-term TIPS correlate weakly with changes in CPI. However, given their relatively higher sensitivity to changes in inflation, short-term TIPS tend to be a better hedge against inflation than their long-term counterparts.

Each of the three indices will provide effective inflation protection from January 2008 to December 2019, as each provides an annual return on top of inflation. Although only the intermediate TIPS index outperformed its Treasury index counterparts during this time period, the results were slightly more convincing over the previous 10- and five-year periods, as seen below in Chart 4:

As is the case with passive index funds in other asset classes, the evaluation of TIPS ETFs should begin with an assessment of the fund’s process, which is primarily determined by its index methodology. A process that broadly represents the set of opportunities available and how managers actively build their portfolios, allowing funds to capture the specific risks and return characteristics of a given market. Again, the valuation for these TIPS can be reduced to the selection of maturity bands, since these bonds are indistinguishable from each other.

Of course, it is also important to evaluate the team in charge of managing the portfolio. It takes the combined skills of a team of portfolio managers and traders to make an index fund perfectly fit their benchmarks.

Since TIPS is a narrow and homogeneous sector of the bond market that is free of credit risk, there is limited potential to outperform (or underyield). Therefore, commission is a very important factor that investors should weigh when comparing strategies that use a similar process.

The best ETF TIPS are those that broadly represent their set of opportunities and charge the lowest fees. The ETFs listed in Appendix 5 are our favorites in the ETF menu. Both of these low-cost options are attractive options for investors who want to protect against unforeseen inflation.

The Vanguard Short-Term Inflation Protected Securities ETF (VTIP) tracks the Bloomberg Barclays US TIPS 0-5 Year Index and charges an annual fee of 0.05%. The fund is invested in TIPS with less than five years remaining until maturity. As a result, it will be more sensitive to changes in CPI relative to long-term funds. In recognition of the quality of the underlying benchmark, its managers’ ability to accurately replicate their bogie performance, and their investor-friendly fees, we recently upgraded their Morningstar analyst ratings to gold from silver.

The Schwab US TIPS ETF (SCHP) tracks the Bloomberg Barclays US Treasury Inflation-Linked Bond Index, which includes all TIPS bonds with at least one year remaining until maturity. We recently upgraded the fund’s Morningstar analyst rating to gold from silver due to its broad benchmarks, lower commissions (0.05%), and the ability to adjust strictly to its bogy.