As many expected the Federal Reserve will only gradually raise interest rates, investors can still hold on to Treasuries for income exposure. However, people may want to consider Treasury inflation protected securities and related exchange traded funds in the event the unrealistically low inflation expectations prove to be wrong.
“With the economy unable to break above this threshold for any length of time, our base case scenario calls for an only modest rise in long-term yields in 2016,” according to Russ Koesterich, Global Chief Investment Strategist and Head of Model Portfolio & Solution Business at BlackRock.
The strategist argues that several factors could provide a 3% ceiling to government yields. For instance, an aging population, lower supply of bonds and persistent institutional demand for fixed-income assets will all help maintain demand, which will support prices and keep yields suppressed – bond prices have an inverse relationship to yields, so higher prices corresponds with lower yields.
Koesterich believes that only a dramatic acceleration in global economic activity or firming inflation expectations would lead to a dip in Treasuries – he is leaning more toward rising inflation expectations, which would diminish the real or inflation-adjusted yield on bonds. As the labor market strengthen and the impact of a stronger dollar and lower energy prices start to diminish, inflationary pressures could rise.
“No, we do not envision a significant surge in inflation,” Koesterich added. “But we do think inflation expectations may be too sanguine. As such, we prefer TIPS to plain-vanilla Treasuries in our bond portfolio.”
Treasury inflation-protected securities, or TIPS, are a type of Treasury security that is indexed to inflation as a way to shield investors from the negative effects of inflation. The securities’ var value rises with inflation as measured by the Consumer Price Index while interest rate remains fixed. TIPS also offer investors another layer of diversification as many aggregate bond funds exclude TIPS from their holdings.