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Investors Buying TIPS ETF for Inflation Protection

tlydon@globaltrend.com (Tom Lydon)

One of the most popular ETFs recently is a fund that invests in U.S. inflation-protected bonds.

Investors added $638 million to iShares Barclays TIPS Bond Fund (TIP - News) in May, according to data from the ETF Industry Association. The $23.5 billion fund was among the top sellers last month.

The inflows suggest some investors are exploring fixed-income funds for inflation protection outside gold and commodities ETFs.

After Friday’s weak jobs report, speculation is growing that the Federal Reserve will announce further stimulus. Meanwhile, there is lingering talk the ECB will be forced to step in again with more easing measures to help Europe’s banking sector and debt crisis.

With Treasury Inflation-Protected Securities or TIPS, the bonds’ principal is linked to changes in the Consumer Price Index.

However, it’s important to remember that since the ETFs invest in Treasury bonds, they can be hurt by rising interest rates.

“TIPS will not perform well if real yields rise along with rising interest rates,” said Russ Koesterich, iShares chief investment strategist.

Other ETFs for this asset class include PIMCO 1-5 Year TIPS (STPZ - News) , SPDR Barclays Capital TIPS (NYSEArca: IPE) and Schwab U.S. TIPS (SCHP - News).

Investors have been buying TIPS even though the bonds have seen yields more into negative territory, which highlights the demand. [TIPS ETFs and Negative Yields]

Morningstar stresses some caveats that investors should keep in mind with TIPS.

“It is important to note that inflation is just one component of interest rates and that changes in the ‘real rate’ or the risk-free cost of capital will cause the value of TIPS to oscillate up or down just like Treasury bonds,” the investment researcher said. “It is also important to note that because of the inflation adjustment on TIPS, the yield you get today is not set in stone, and investors should be prepared for it to move up or down depending on the movements of the CPI.”

TIP, the iShares TIPS fund, is trading near an all-time high although the ETF has pulled back somewhat in June as Treasury yields have bounced a little.

The inflation “break-even rate” is important to watch. It is determined by comparing the yields of regulator government bonds against inflation-protected securities of the same duration, usually 10 years. If inflation averages more than the breakeven rate over the next decade, then investors would be better off owning TIPS than normal Treasury bonds.

iShares Barclays TIPS Bond Fund

Full disclosure: Tom Lydon’s clients own TIP.