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TIPS ETFs Fight Inflation ... But Not the Kind You Expect

"Inflation-protected" doesn't always translate to inflation hedging. It's time to debunk common myths about the role of TIPS and the ETFs that buy them.

Morningstar Fund Analysts, 12/12/2012

With a name like Treasury Inflation-Protected Security, perennially favored TIPS certainly seem like a natural choice for an inflation hedge. Unfortunately, TIPS funds don’t do that particular job as well as many might expect. An inflation hedge is an investment that co-moves with inflation and preserves purchasing power, but the TIPS indexes tracked by the largest exchange-traded funds have historically exhibited only a small positive level of correlation to inflation--far from a perfect inflation hedge in the traditional sense.

Despite their low correlation to inflation, TIPS funds remain wildly popular: About $27 billion is invested in the 10 TIPS ETFs currently on offer. These funds may not be a perfect inflation hedge, but they are a great option for the investor who thinks the market is underestimating future inflation--in other words, for hedging against unexpected inflation.

TIPS can be considered the closest thing to a truly risk-free asset, as they combine the security of Treasuries with inflation protection in the form of Consumer Price Index-adjusted principal. The CPI represents the amount that an urban consumer would need to spend to purchase a certain basket of goods and services. Inflation will drive the price of that basket higher and deflation will make it cheaper, which is reflected in increases/declines in the CPI. When the CPI goes up, TIPS’ principal is adjusted upward accordingly. Even though the interest rate on the bond remains the same, the semiannual coupon is paid based on the adjusted principal. Through this process, a TIPS’ principal and interest payments are protected against inflation as measured by the CPI.

Today’s risk-off attitude means that investors have willingly snapped up TIPS and related funds, despite negative real yields on new shorter-maturity TIPS issues caused by a nominal rate lower than the expected future rate of inflation. Buying a TIPS at issuance and holding it until maturity is a guaranteed way to protect that lump of cash from inflation (as determined by the CPI) until a later date. Many investors buy a laddered portfolio of individual TIPS to immunize future cash flow, which is a straightforward and generally successful way to preserve purchasing power between two points in time. However, TIPS funds behave differently.

Like any bond, TIPS pricing is mainly driven by changes in the real interest rate. When real interest rates rise, TIPS fall, and vice versa. Therein lies the rub. Changes in the nominal rate can and do move TIPS pricing, even during periods of unchanging inflation. An investor buying a single bond and holding it until maturity is less likely to be concerned with these price fluctuations. However, investors in TIPS ETFs who are using these funds for more-tactical purposes are likely to take notice. Most TIPS indexes have high durations, so changes to the nominal rate have a large impact on the prices of the underlying bonds. The impact of changes in inflation expectations can be swamped by gyrations in underlying rates, which goes a long way toward explaining why broad TIPS funds exhibit such low levels of correlation with inflation. That said, shorter-duration TIPS indexes are somewhat more correlated to inflation, given their lesser degree of interest-rate sensitivity.

Understanding the difference between expected and unexpected inflation is central to understanding TIPS and forming an investment thesis. Ask yourself: Do you think future inflation will outpace the market's current expectations? An easy way to calculate the market's current expectation for future inflation is to look at the break-even inflation rate, which is the difference in the yields of TIPS and Treasury bonds of the same maturity. If inflation ends up coming in higher on average than the break-even rate, the TIPS investor is better off. The easy part is calculating the market’s implied expectations for future inflation; it is much harder to come up with an accurate prediction of future inflation and invest accordingly.

Today's inflation rate is well below the historic average, despite the massive monetary stimulus that has been applied by the Fed. This expansionary monetary policy has been enacted to encourage spending, but it also has the potential to eventually erode purchasing power. Quantitative easing's future impact on inflation may be greater than the market expects, and if it is, TIPS will beat Treasuries.

For some historical perspective, the 10-year break-even rate of inflation was as low as 0.04% in 2009 and has averaged about 2% over the past decade. When the break-even rate is below average, it suggests that TIPS may be relatively cheap versus the Treasury with a corresponding maturity. Right now, the 10-year break-even rate of about 2.5% is above the trailing 10-year average, which has led many to caution that TIPS are overpriced. However, the long-term average inflation rate has been closer to 3%. If you think inflation will ultimately exceed current expectations, TIPS might still be priced attractively enough to offer inexpensive inflation protection. For such investors, the menu of TIPS ETFs may offer some useful tools.

Morningstar fund analysts cover more than 1,700 mutual funds and write regular commentary covering fund industry news, fund investing trends, picks, portfolio planning, international investing, and more.

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