The upside of betting on inflation

Treasury inflation-protected securities are gaining popularity as a yield play

Aug 29, 2019 @ 1:56 pm

By Jeff Benjamin

With both interest rates and inflation near the floor, fixed-income investors are finding the best opportunity for yield in Treasury inflation-protected securities, or TIPs.

"Right now, smarter people are jumping into TIPS because real rates are at all-time lows," said David Gingrich, vice president of the adviser consulting group at Advisors Asset Management.

"The global powers have been trying to stoke inflation for many years, and it's typically not wise to fight those powers," Mr. Gingrich said. "Combine that with the inflationary impact of tariffs, and you're not giving up much opportunity cost by going with TIPS over a Treasury bond."

TIPS are structured to take advantage of inflation by paying investors the rate of inflation in addition to the fund's stated yield.

According to ETF.com, the Schwab U.S. TIPS ETF (SCHP) led all other ETFs during the week ending Aug. 26, with net inflows of $973 million, while the Vanguard Short-Term Inflation-Protected Securities ETF (VTIP) had net inflows of $507 million.

The TIPS play is in some ways a double-edged sword, because the protection that kicks in when inflation rises can cut the other direction if inflation declines.

For example, the five-year Treasury bond is currently yielding 1.4%, which compares to 1.5% for comparable TIPS.

But, according to Mr. Gingrich, "if inflation dropped 100 basis points tomorrow, the TIPS yield would be in the neighborhood of 50 basis points."

On the flip side, if inflation jumped by 100 basis points, that same TIPS yield would jump to near 2.5%.

"Most people are saying we're running pretty close to lows as far as inflation goes, so they're seeing more upside than downside with TIPS," Mr. Gingrich said.

Paul Schatz, president of Heritage Capital, described the recent rush into TIPS as "just another yield play, as Treasuries went up 8% more than TIPS in August alone."

"Some people likely view TIPS as a better value compared to straight Treasuries right now," he said. "I don't see inflation picking up until the other side of the next recession. I'm much more concerned about disinflation or mild deflation when the economy recesses."

Marc Pfeffer, chief investment strategist at CLS Investments, expects that the Federal Reserve's current monetary policy, combined with the global trade wars, is likely to spark some inflation.

"There is some perceived value in TIPS, however they have underperformed nominal Treasuries," he said. "In all candor, I've not been in favor of TIPS over nominal Treasuries."

Instead of picking sides, David Hultstrom, chief investment officer at Financial Architects, keeps most of his client portfolios evenly balanced between TIPS and Treasury bonds to cover all the bases.

"I don't ever think I'm smarter than the market, so unless you think the market is mispricing inflation, you might as well own both TIPS and nominals," he said. "I like to be neutral with respect to inflation, unless a client has some unusual inflation exposure in the rest of the portfolio."

For example, if a client has a pension with no cost-of-living adjustment, TIPS will help offset the negative effects of inflation.

On the other hand, if a client owns a lot of rental properties with fixed-rate mortgages that will benefit from inflation, Mr. Hultstrom will reduce the TIPS exposure.

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