TIPS

When markets crash, investors buy bonds. U.S. treasury bonds and U.S. treasury bond ETFs continue to be the ultimate safe haven in times of market turmoil. But there are risks to owning treasuries, including inflation. Some treasury bond ETFs add inflation protection.

The chart below compares a plain vanilla U.S. treasury bond benchmark, the iShares Barclay 7-10 Year Treasury Bond (NYSEArca:IEF) with the equity benchmark Standard and Poors Depositary Receipts (NYSEArca:SPY)

As the chart shows, treasury bond ETFs have been pretty steady over the last six months, compared with equity. But this steadiness is not inevitable. There are two distinct threats to the value of U.S. treasury bond ETFs.

The first threat is the value of the dollar itself. Inflation can erode the value of a dollar and thereby the value of as treasury bond ETF. In an inflationary situation, the principal of a treasury bond is returned but over time it has become less valuable compared to when the bond was issued.

In the ETF family there is a partial solution to the inflation problem: the TIPS bond ETF. TIPS stands for Treasury Inflation Protected Securities. In an inflationary situation, a TIPS bond ETF will continue to yield interest payments and the principal will increase with the CPI (Consumer Price Index). The chart below compares the first and largest TIPS ETF is the iShares Barclays TIPS Bond (NYSEArca:TIP), with IEF.

Like IEF and other U.S. treasury instruments, TIP has done well lately, less because of the inflation covenant (The CPI index has been increasing by 0.2% or less for the past six months), but because of investor interest in low-risk, dollar denominated instruments. In some ways this performance is remarkable. The U.S. is running its largest budget deficit ever, expected to touch 1.5 trillion in 2010 alone. Investors have more immediate worries, for now.

A sovereign debt crisis in Greece and a looming crisis in Spain and Portugal have reversed the euro's decade-long assent against the dollar. As the euro has weakened, money has flooded into dollars and into U.S. treasury ETFs. As long as speculation circulates that the euro is threatened, the demand for dollars and U.S. treasuries by implication will likely remain strong. The chart below shows the inflation ETF TIP and an ETF that tracks the dollar, the PowerShares DB US Dollar Index Bullish (NYSEArca:UUP).

TIP has followed the dollar higher. Will the dollar continue to strengthen? Right now the dollar looks unstoppable. But the dollar is not backed by gold. It is not backed by anything other than a promise to pay-- from the U.S. government, the world's greatest debtor. Yes, the world's greatest debtor manages the U.S. taxpayer, arguably the world's greatest productive asset.

But even so the U.S. is highly leveraged. U.S. debt is approaching 100% of GDP. Although the rating agencies are a laughingstock for many investors after their complicity in subprime debacle and their helpfulness doubtful, Moody's recently has talked about stripping the U.S. of its AAA rating. Its not hared to see why.

Because U.S. treasury bonds are denominated in U.S. dollars, default is pretty much inconceivable (the government only needs to run the presses to fulfill its dollar obligations). If the government deals with this problem through inflation (printing money) then the performance of treasury bond ETFs like IEF and TIP will bifurcate. Mid-term treasury bond ETFs like IEF will fall because of inflation but the CPI index will rise and the value of a TIPS bond ETF will increase.

A second threat to the value of U.S. treasury bonds is the value of other U.S. treasury bonds. In this scenario, IEF will underperform. TIPS ETFs will also underperform. If the U.S. fights inflation by raising interest rates, the value of the dollar remains strong and may even increase in relation to other currencies but new treasury bonds paying a higher interest rate than the old bonds will erode the value of existing treasury bonds. Like any other market, the market for U.S. treasuries is self-evidently not immune to selling. An investor could minimize this risk by investing in a shorter term TIPS portfolio, like PIMCO's Broad U.S. TIPS INDEX (NYSEArca: TIPZ). This will involve giving up some yield.

But ultimately in environment of rising interest rates, an investor might be better off not owning bond ETFs at all, but instead investing in a gold or precious metals ETF. Another possibility would be an ETF that generates strong dividends, such as a utility fund, or a fund backed by hard assets in commodities or basic materials. ETFs covering these assets classes are a store of value when either the dollar weakens or in a rate increasing environment when newly issued treasury bonds pay higher coupons than older bonds.

U.S. TIPS Bond ETFs along with their expense ratios follow:

iShares Barclays TIPS Bond Fund (NYSEArca:TIP), 0.2%

SPDR Barclays Capital TIPS (NYSEArca:IPE), 0.19%

PIMCO Broad U.S. TIPS Index (NYSEArca:TIPZ), 0.2%

PIMCO 1-5 Year U.S. TIPS Index (NYSEArca:STPZ), 0.2%

PIMCO 15 Year U.S. TIPS Index (NYSEArca:LTPZ), 0.2%