For TIPS, Shorter Is Better

Thanks to several years of historically low rates, funds like  iShares Barclays TIPS Bond (TIP) have been the most popular exchange-traded way to invest in Treasury Inflation-Protected Securities. However, with rates increasing and subdued inflation expectations, long-duration ETFs like TIP may no longer be the best choice for most investors. Broad TIPS ETFs such as TIP are highly sensitive to interest-rate changes, are a poor inflation hedge, and protect against unexpected inflation over a time period that might be too long for most. Investors worried about rising rates should consider targeting the short end of the curve instead. Shorter-duration TIPS funds are less exposed to interest-rate risk, and are also slightly more correlated to inflation than their longer-dated brethren. Several short-duration TIPS ETFs have emerged in recent years to address these issues, and our favorite is Vanguard Short-Term Inflation-Protected Securities ETF (VTIP), which launched in November last year. This fund has an average duration of just 2.6 years, and its 0.10% annual expense ratio makes it the cheapest way to buy short-duration TIPS bonds. Most TIPS ETFs cost twice as much. Vanguard shifted its target-date funds into VTIP's corresponding mutual fund shares this year, showing the firm’s conviction that short-duration TIPS provide purer protection against inflation. We think VTIP’s cost advantage will give it the edge over other short-duration competitors.

With rates on the rise, investors are increasingly shifting their fixed-income assets into high-quality, shorter-duration bonds. TIPS should be no exception. As is the case with all bonds, rate increases reduce the attractiveness of TIPS bonds already on the market. If new bonds will pay a higher interest rate, why buy the lower rate today? The bond sell-off and increase in long-term rates in the second quarter of 2013 hit TIPS pricing hard, and particularly devastated the iShares Barclays TIPS ETF, which has lost 8.12% in the year to date. Short-dated TIPS, which are less sensitive to rate changes, suffered significantly less. VTIP has lost only 1.76% in the year to date and should continue to outperform relative to TIP if rates maintain their upward climb. This fund is a good fit for investors who have determined that TIPS have a place in their asset allocation and are concerned about interest-rate sensitivity as the Fed begins to end its policy of easy money. On the topic of asset allocation, Christine Benz recently wrote an excellent article about the appropriateness of owning TIPS for different investors.

The lesser interest-rate sensitivity of short-term TIPS ETFs is only one of their benefits. ETFs like VTIP are a better inflation hedge than broad, long-duration funds like TIP. An inflation hedge is an investment that 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. This is an effect of how changes in the nominal rate can and do affect TIPS pricing, even when inflation expectations remain constant. Investors who buy individual TIPS can ignore these price fluctuations: Individual TIPS, when held until maturity, are a good inflation hedge because they preserve purchasing power between two points in time. TIPS ETFs, however, have no target maturity date and own several different bond issues. As a result, changes in the nominal rate cause their aggregate portfolios to move out of sync with inflation. The largest broad funds buy the full spectrum of TIPS issuance, owning more than 30 different bonds, and have durations in excess of eight years. These funds are negligibly correlated with inflation. However, the lesser interest rate sensitivity of short-duration TIPS ETFs (and smaller portfolios) makes them several times more correlated with inflation than long-duration funds. However, investors should not expect VTIP to exhibit a five-year correlation with inflation of more than 30%. Buying a laddered portfolio of individual TIPS to immunize future cash flow is a straightforward and generally successful way to hedge against inflation.

Although VTIP is a more effective inflation hedge than broad TIPS ETFs, it really shines as a hedge against unexpected inflation. The market's current expectation for future inflation is indicated by the break-even inflation rate, which is the difference in yields between TIPS and ordinary Treasury bonds of the same maturity. A TIPS bond will outperform its corresponding maturity Treasury if inflation is higher on average than the break-even rate during the lifetime of the bond (i.e., inflation comes in unexpectedly high). If an investor thinks the market is underestimating the short-term future rate of inflation, or simply wants to hedge against the possibility, VTIP is a good way to invest accordingly.

The depressed prices of TIPS bonds may be welcome news to investors looking to buy cheap insurance against higher-than-expected inflation. Today’s 10-year break-even rate of inflation is about 2.10%, which is significantly lower than the long-term average inflation rate of 3%. The five-year break-even rate is even lower at about 1.80%. For historical perspective, the 10-year break-even rate of inflation was as low as 0.04% in 2009 and averaged about 2.2% over the past decade. When the break-even rate is below-average, it suggests that TIPS may be relatively cheap compared with a Treasury with a corresponding maturity. Right now, the 10-year break-even rate has declined from an above-average 2.5% last year to fall below the trailing 10-year average, which suggests the market is at its cheapest in several years. If you think inflation will ultimately exceed current expectations, TIPS might now be priced attractively enough to offer inexpensive inflation protection. Investors concerned about the Fed's quantitative easing program and its impact on future inflation may find the recent sell-off to be a good buying opportunity.

An important note: In periods of deflation, this fund can suspend distributions, which are generally paid monthly. Most of a TIPS' inflation adjustment is paid at maturity, but investors are still taxed on the inflation-adjusted principal increase every year. To prevent investors from being taxed on this "phantom" income, VTIP pays out the would-be inflation adjustment in addition to the coupon payment. Most TIPS ETFs employ this mechanism. This means that instead of being taxed annually on income that has not yet been received, owners of VTIP actually receive the income. Although this solution makes tax season more straightforward, it means distributions can sometimes be suspended. If the CPI declines, investors receive the realized negative inflation adjustment, which will reduce the distribution or even cancel it out until the entire decline is distributed.

Other Alternatives
Investors have a variety of short-duration TIPS ETFs to choose from. We also like  PIMCO 1-5 Year US TIPS Index ETF (STPZ), which charges a 0.20% expense ratio.  iShares Barclays 0-5 Year TIPS Bond (STIP) tracks the same index as VTIP, but costs 0.20% a year. Two new TIPS offerings let investors fit TIPS into a fixed-income portfolio without introducing duration volatility:  FlexShares iBoxx 5Yr Target Duration TIPS ETF (TDTF) and  FlexShares iBoxx 3Yr Target Duration TIPS ETF (TDTT), which are structured to offer a target duration of five and three years, respectively. These funds charge 0.20% a year.

Actively managed  PIMCO Real Return (PRTNX) has a Morningstar Analyst Rating of Gold. This fund aims to provide cost-efficient exposure to TIPS and inflation-linked bonds by seeking better execution than passive investors. The goal is to track the fund's TIPS index while targeting additional real returns. Investors with access to the fund's Institutional shares pay 0.45% a year. 

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