Inflation Prep Is Becoming More Relevant Thanks to Low Rates

With interest rates poised to stick near historical lows for several more years at least, investors need to consider inflation preparation. The FlexShares iBoxx 3-Year Target Duration TIPS Index Fund (NYSEArca: TDTT) is an ETF that helps accomplish that objective.

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

“Falling rates increase the value of future cash flows from investments such as stocks. Even in recessions, lower rates can often offset the impact of lower cash flows,” reports Randall Forsyth for Barron’s. “Finally, central banks’ ability to cut rates is their main tool to boost the economy in downturns. At zero, they’ve lost the power to lower discount rates or put a floor under earnings.”

TDTT would be particularly useful in an environment where inflation data exceeds forecasts, meaning investors should monitor the breakeven inflation rate.

Time for TDTT

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 the interest rate remains fixed. TIPS also offers investors another layer of diversification as many aggregate bond funds exclude TIPS from their holdings.

“Another key difference is that monetary policy’s focus has shifted from trying to put a lid on inflation to placing a floor under inflation,” according to Barron’s.

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.

Investors now argue that the Federal Reserve’s rate cuts this year have bolstered the outlook on inflation, with some even contending that inflation may rise fast enough to force the Fed to hike rates.

“By its words and actions, the Fed has made clear it wants to hold down rates as long as unemployment remains elevated from the severe economic hit from the coronavirus,” reports Barron’s.

The principal of a TIPS bond rises along with inflation but decreases with deflation as measured by the Consumer Price Index. Furthermore, the fixed interest rate is applied to the adjusted principal, so interest payments rise with inflation and fall with deflation.

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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.