In anticipation of rising inflationary pressures ahead, fixed-income investors have turned to a number of Treasury inflation protected securities and bond-related exchange traded funds.
This year, investors have been pouring into ETFs such as the iShares TIPS Bond ETF (NYSEArca: TIP) and the Schwab U.S. TIPS (NYSEArca: SCHP).
While inflation expectations may remain muted now, investors are already looking into TIPS as a hedge against rising prices ahead.
TIPS returns are affected by interest-rate risk as well as changes in the principal value when the Consumer Price Index moves. TIPS will adjust their principal value upward in response to a higher CPI, but the reverse occurs during periods of deflation.
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.
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The securities’ par 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.
“We have opened an overweight position in US Treasury Inflation Protected Securities (TIPS) versus standard government bonds. Fed officials seem willing to accept a period of above-target inflation to ensure that economic growth and job market momentum is maintained. This was underlined in Yellen’s comments on 14 October that the Fed was considering “temporarily running a ‘high-pressure economy,” said UBS in a note posted by Barron’s.
[related_stories]Investors will typically look at TIPS ahead of an inflationary period since buying TIPS after inflation has gone up means that the security has already priced in the inflation and investors would likely be overpaying for the TIPS exposure.
Potential investors should also be aware that TIPS are generally more volatile than traditional nominal Treasuries due to the inflation adjustments to their principal value.
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“The market is currently pricing medium-term inflation at around 1.4% to 1.6%. The Fed’s inflation target of 2% is referenced to the personal consumption expenditures (PCE) index, while TIPS are linked to the consumer price index for all urban consumers (CPI-U), which typically runs 0.3 of a percentage point higher. As long as PCE inflation runs above 1.25% or so, TIPS should outperform nominal bonds. Given the steady economic backdrop and the Fed’s attitude, we believe this is likely,” adds UBS in the note posted by Barron’s.
For more information on the fixed-income market, visit our bond ETFs category.
iShares TIPS Bond ETF (NYSEArca: TIP)
