U.S. Markets closed

TIPS ETFs as an Inflation Hedge

tlydon@globaltrend.com (Tom Lydon)

ETFs that hold Treasury Inflation-Protected Securities have been popular with investors seeking an inflation hedge because the bonds’ principal is linked to changes in the Consumer Price Index.

However, it’s very 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.

“Despite its inflation protection, fluctuating interest rates still lead to volatility here,” Morningstar adds in an analyst report on iShares Barclays TIPS Bond Fund (TIP - News).

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

Koesterich said TIPS are his favorite inflation fighters, trailed by commodities, cash, equities, real estate. Nominal bonds are at the bottom of the ladder because inflation kills the purchasing power of fixed-income securities.

The strong demand for TIPS is evidenced by the fact that investors are buying the securities even though the bonds have negative yields. [TIPS ETFs and Negative Yields]

Although the iShares strategist sees inflation as a “significant risk for investors in 2013 and beyond,” he doesn’t expect a sharp spike in inflation this year.

“First, despite a recent rise in bank lending, most of the extra stimulus money created by the Federal Reserve is still sitting on bank balance sheets,” Koesterich wrote at the iShares blog. “Also, as this money starts hitting the supply, there will likely be a lag before inflation hits. Historically, it has taken about two to three years before growth in the money supply has translated into a meaningful acceleration in inflation.”

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.”

PIMCO Total Return ETF (BOND - News) manager Bill Gross has been warning investors about the risks of owning nominal Treasuries. He recently said if investors want to own long Treasuries, buy them in TIPS form. [PIMCO’s Gross Favors Shorter Duration, Inflation-Protected Bonds]

Finally, it should be noted that some investors think the way the government weights the components of the the CPI results in the benchmark underestimating the inflation rate that consumers are actually experiencing.

iShares Barclays TIPS Bond Fund

Full disclosure: Tom Lydon’s clients own TIP.