The Federal Reserve’s 50-basis point interest rate cut revealed earlier this week is prompting speculation that inflation could rise after the coronavirus is contained, leading some investors to revisit Treasury Inflation Protected Securities (TIPS) and ETFs, such as the iShares TIPS Bond ETF (NYSEArca: TIP).
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 offers investors another layer of diversification as many aggregate bond funds exclude TIPS from their holdings.
“Investors plowed nearly $500 million into BlackRock Inc.’s $22 billion iShares TIPS Bond ETF, which tracks inflation-protected securities, on Tuesday,” reports Bloomberg. “The cash influx was the biggest since April 2015 and followed the Fed’s surprise rate reduction, geared toward cushioning the world’s largest economy from the impact of the coronavirus.”
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.
“While inflation expectations tend to rise after the Fed lowers rates, bond-market measures show traders remain deeply skeptical. Still, the U.S. economy was on solid footing before the outbreak and that could translate into a pick-up in inflation when the disease subsides, said Thomas Simons, senior money market economist at Jefferies LLC,” according to Bloomberg.
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.
“Betting on an inflation revival was a popular bond call coming into 2020, with the likes of Pacific Investment Management Co. and State Street Corp. backing the trade. Momentum quickly sputtered as the virus rocked financial hubs worldwide, leaving major cities in virtual lockdown and disrupting supply chains,” reports Bloomberg.
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