When Using TIPS ETFs, Keep It Short and Sweet

With so much talk about possible increases in the Consumer Price Index (CPI), it’s not surprising advisors and investors are revisiting a popular inflation-fighting asset class: Treasury inflation protection securities (TIPS).

Something that often goes overlooked with TIPS is duration risk. That stands to reason because credit risk is non-existent. Another element to consider is that TIPS’ durations are often fluid as they’re levered to changing inflation expectations.

A way for investors to contend with near-term inflation while reducing rate risk is by minimizing duration. Enter the FlexShares iBoxx 3-Year Target Duration TIPS Index Fund (NYSEArca: TDTT).

“Duration, is a key measure of a bond’s sensitivity to interest rate changes, and TIPS’ durations can change frequently with changing inflation expectations. The reason for this is future cash flows, a key determinant of duration, are driven by inflation expectation,” according to FlexShares research.

A Good Time for ‘TDTT’

The $1.44 billion TDTT has 20 holdings with a weighted average maturity of 3.48 years and a modified adjusted duration of 3.10 years. Modified adjusted duration gauges markets’ expectations for inflation at that point in time, not months or years out. TDTT’s duration may be right in the sweet spot of the three to five years’ worth of duration FlexShares advises investors to consider when evaluating TIPS strategies.

In fact, TDTT is relevant at a time when market observers view inflation as transitory, meaning that when it arrives in earnest, its stay is likely to be brief. Said differently, there are risks involved with holding long-duration TIPS if inflation itself isn’t a long-lasting scenario.

“If inflation expectations rise or fall, expected future coupons adjust accordingly. For example, a TIPS strategy with a duration of 5 years may see its duration rise if inflation expectations fall—increasing the interest rate risk in a client’s portfolio,” notes FlexShares.

Another benefit of TDTT is that although it’s a passively managed fund, its underlying index – the iBoxx 3-Year Target Duration TIPS Index – is rebalanced on a monthly basis to keep its duration as close to three years as possible. There are also some tax restraints within the index as it cannot repurchase bonds sold a month prior as to avoid running afoul of wash sale consequences.

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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.