Inflation appears to be benign, but that doesn’t mean investors should gloss over ETFs, such as the FlexShares iBoxx 3-Year Target Duration TIPS Index Fund (NYSEArca: TDTT).
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.
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 $1.16 billion TDTT, which has a modified adjusted duration of just 3.08 years, is worth examining in preparation of an unexpected bump in inflation.
“Realized inflation can exceed expected inflation. Unexpected inflation is harmful to bond investors.
Treasury Inflation-Protected Securities can protect investors from the adverse effects of unanticipated inflation,” said Morningstar in a recent note.
Tipping A Terrific TDTT
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. TDTT has 20 holdings and a weighted average maturity of 3.92 years.
“As their name implies, TIPS provide a degree of inflation protection, in the form of regular adjustments to their principal to reflect observed inflation–therefore protecting against unexpected inflation,” according to Morningstar. “These bonds are issued by the U.S. Treasury Department in terms of five, 10, and 30 years. Because they are issued by the Treasury, they present the same amount of credit risk as nominal (non-inflation-adjusted) Treasury bonds. As of January 2020, there were 44 distinct TIPS bonds with a total outstanding face value of approximately $1.5 trillion.”
TDTT would be particularly useful in an environment where inflation data exceeds forecasts, meaning investors should monitor the breakeven inflation rate.
“The breakeven inflation rate represents the spread between the yield of a nominal Treasury bond and a TIPS bond of the same maturity,” said Morningstar. “It is a useful metric to gauge the difference between expected and realized inflation. But Treasury bonds carry inflation risk, which is factored into their yield via a premium which pushes the rate away from its theoretical equilibrium. As such, this spread is only a proxy.”
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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.