Inflation-Busting With ETFs

This year is something of a perfect storm for Treasury Inflation Protected Securities or TIPS. Inflation is an increasingly important topic for the Federal Reserve and investors have been pouring billions of dollars into fixed income exchange traded funds.

Federal Reserve Bank of San Francisco President John Williams said earlier this year that inflation could rise faster than the pace at which the central bank is currently ticking. The renewed boom in exchange-traded funds holding Treasury Inflation-Protected Securities (TIPS) confirms investors and money managers are betting that inflation might just be an issue the Fed is not paying enough attention to.

ETFs such as the iShares TIPS Bond ETF TIP and the Schwab U.S. TIPS ETF SCHP are among the primary destinations for investors looking to add inflation hedges to their portfolios.

“One of the most important measurements to be aware of regarding TIPS is the break-even inflation rate. This is the difference between the yield of a nominal Treasury bond and the yield on a TIPS of the same maturity. The break-even rate is often viewed as the market’s expectation for inflation. As of this writing, the break-even rate on 10-year maturities stood at 1.58%, compared with a long-term average of 2.12%. In February 2016, the break-even rate went as low as 1.2%,” said Morningstar in a recent note.

The rub for investors with hedging against inflation via ETFs is these funds are not great income generators. For example, the real yield on TIP, the iShares product, is just 0.08%, according to issuer data. Real yield is an investment's returns adjusted for inflation. 

The lack of yield is not chasing investors away. Actually, the opposite is true. Year-to-date, TIP has added $3.23 billion in new assets to bring its assets under management tally to just under $18 billion.. SCHP, the Schwab TIPS ETF, has added $239 million in new assets.

SCHP charges just 0.07 percent per year, or $7 for every $10,000 invested, making it the least expensive TIPS ETF on the market. SCHP has a duration, a bond's sensitivity to interest rate changes, of 7.8 years.

“So far this year, the inflation-protected bond ETF category has done well relative to the intermediate-term bond ETF category, returning 3.93% versus 3.38% for the year to date through April 2016. This outperformance is the result of a variety of factors, including widening break-even rates and falling long-term interest rates,” adds Morningstar.