Investors flood TIPS funds as Trump win stokes inflation concerns

Funds that invest in Treasury Inflation Protected Securities saw a net inflow of $1 billion the week ended Nov. 9, the second-largest since records began in 2002

Nov 11, 2016 @ 11:43 am

By John Waggoner

Investors are taking TIPS seriously these days.

Funds that invest in Treasury Inflation Protected Securities saw a net inflow of $1 billion the week ended Nov. 9, the second-largest since records began in 2002, according to Thomson Reuters Lipper. The record inflow was in April 2015.

Fund flows typically follow performance, and TIPS have fared well this year. TIPS funds have gained 5.29% this year, vs. a 2.10% gain for intermediate government bonds, according to Morningstar, the Chicago investment trackers. The tip-top TIPS fund, DFA LTIP Institutional (DRXIX), has jumped 13.04%.

At least at the moment, inflation appears whipped. The current TIPS yield implies a 10-year inflation rate of 1.70%. The Consumer Price Index, the government's main measure of prices, rose just 1.5% in the 12 months ended September. Excluding food and energy, the CPI gained 2.2%.

Within those figures, however, is plenty of room for debate. Gasoline prices, for example, are down 6.5% over the past 12 months, and food at home has fallen 2.2%. Used cars and trucks fell 4.1%. But the cost of medical care jumped 4.8%, and hospital services gained 6%. Recent increases in health-care insurance premiums have also hit consumer pocketbooks.

And wages seem to be rising as well: You can't have a wage-price spiral without rising wages. Real — that is, inflation-adjusted average hourly earnings — increased 1%, seasonally adjusted, from September 2015 to September 2016.

TIPS yields imply a 10-year inflation rate of 1.7%
Source: Federal Reserve Bank of St. Louis, 10-Year Breakeven Inflation Rate [T10YIE], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/T10YIE, November 10, 2016.

The election may have also raised inflation fears. President-elect Donald Trump has promised to increase spending in a number of areas, including the military and infrastructure, while cutting taxes. All things being equal (and absent a promised 4% growth rate for gross domestic product), a program of increased spending and decreased revenues would increase both the annual deficit and the debt.

The Tax Policy Institute estimates that Mr. Trump's plan — subject, of course, to approval by Congress — would cut federal revenues by $9.5 trillion over 10 years before accounting for interest costs or macroeconomic feedback effects. “The plan would improve incentives to work, save and invest,” the institute's white paper said. “However, unless accompanied by very large spending cuts, it could increase the national debt to nearly 80% of gross domestic product by 2036, offsetting some or all of the incentive effects of the tax cuts.

As inflation hedges, TIPS have their drawbacks. For one thing, they're still bonds, and bond prices tumble when interest rates rise. TIPS funds lost an average 0.45% in the past month as interest rates rose. That's still less of a fall than experienced by intermediate-term government bonds, which fell 0.89%. Increases to TIPS bonds — which is the way they compensate for inflation — are also taxable as interest in the year in which they are paid. In many cases, TIPS funds are best invested in tax-deferred accounts.

But they also have their advantages. TIPS peg their increases to the headline CPI, which includes food and energy. For those expecting a rise in oil prices, TIPS are a somewhat milquetoast way to bet on that. And, of course, if inflation does soar, TIPS will offer investors some protection.

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