Inflation has been benign for most of the current bull market in U.S. equities, but data suggests that is changing, which could mean it is time for fixed income investors to consider Treasury Inflation Protected Securities, or TIPS.
ETF investors can gain exposure to Treasury inflation protected securities through a number of options, including the iShares TIPS Bond ETF (NYSEArca: TIP), Schwab U.S. TIPS (NYSEArca: SCHP) and SPDR Barclays TIPS ETF (NYSEArca: IPE).
“Investors are slowly waking up to an outlook of mildly higher U.S. inflation amid a backdrop of solid economic growth,” said BlackRock in a recent note. “This year’s surprise was better-than-expected growth coinciding with cooling inflation, partly due to one-off factors. We see that changing in 2018 as the U.S. economic slack created by the deep 2007–09 recession disappears.”
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.
TIP is home to $24 billion in assets under management, making it the largest of the TIPS ETFs. The ETF has an effective duration of 7.61 years. Duration measures a bond’s sensitivity to changes in interest rates.
“2018 is likely to see an important transition in the U.S. economy,” said BlackRock. “We see economic slack mostly disappearing as the labor market strengthens and the expansion motors on. Inflation expectations were dented this year due to the surprise slowdown, tied to major one-off drops and moderation in some categories such as housing. Yet we see inflation expectations firming up as prices climb at a gradual pace.”
It is widely expected that the Federal Reserve will raise interest rates at its December meeting, its third such move this year. However, the pace of rate hikes is expected to slow in 2018 and market observers believe that any corresponding increase in the U.S. dollar is also likely to be gradual.
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.
For more information on Treasury inflation protected securities, visit our TIPS category.