Treasury Inflation-Protected Securities (TIPS) are popular among fixed income investors looking to protect against the scourge of inflation and exchange traded funds make it easier to access TIPS.

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.

The FlexShares iBoxx 3-Year Target Duration TIPS Index Fund (NYSEArca: TDTT) is one of the more compelling options to consider among TIPS ETFs.

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’ 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.

TDTT “offers exposure to the Treasury Inflation-Protected Securities market while maintaining a three-year target duration for a reasonable fee. Its short and targeted duration provides a high correlation to immediate inflation changes and reduces unintended interest-rate risk. However, it has a lower yield than its peers, and there are comparable funds at lower costs,” said Morningstar in a recent note.

TDTT, which debuted nearly six years ago and has over $2 billion in assets under management, carries a bronze rating from Morningstar. Other ETFs in this category include Vanguard Short-Term Inflation-Protected Securities ETF (NYSEArca: VTIP), PIMCO 1-5 Year US TIPS Index ETF (NYSEArca: STPZ), iShares Barclays 0-5 Year TIPS Bond (NYSEArca: STIP) and the FlexShares iBoxx 5Yr Target Duration TIPS ETF (NYSEArca: TDTF).

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.

Related: Using ETFs to Manage Inflation Risks

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.

“Given the reduced interest-rate risk, this fund would continue to exhibit a direct relationship with the CPI and inflation changes. The primary source of the fund’s return is the inflation-indexed coupon payments because the short duration minimizes the price volatility. This fund could be a good option for an investor looking for an instrument that closely reflects immediate shifts in CPI and inflation,” according to Morningstar.

For more information on Treasury inflation protected securities, visit our TIPS category.

The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.

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