Fight Inflation With TIPS ETFs

Investors worried about inflation should consider investing in one of the several ETFs specializing in Treasury Inflation-Protected Securities, or TIPS. TIPS are government-issued treasury bonds indexed to the Consumer Price Index (CPI). The idea behind a TIPS bond is that an investor holding this instrument will have a secure return, guaranteed by the government. But unlike conventional treasury bonds, he will not see that return eroded by inflation.

How does this work? When inflation increases, the principal and interest of TIPS bond increases. When inflation decreases, the principal and interest in these bonds decreases, always in an amount corresponding to the CPI. Upon maturity the owner of a TIPS bond is paid either the original principal or adjusted principal, whichever is greater.

A TIPS ETF is a portfolio of these TIPS bonds. Individual TIPS bonds are issued with a specific maturity-- typically 5, 10, or 20 years. Bundled into an ETF, the capital from mature bonds is re-invested and the portfolio is adjusted to adhere to hold to a maturity and duration schedule. TIPS ETFs make TIPS bonds easy to own because a basket of these securities can be bought efficiently and with a single transaction.

Though TIPS have a guaranteed return, the price of TIPS may be driven by inflation expectations. Most commonly the price of a TIPS bond and the price of plain vanilla treasury bond, without a covenant for protecting investors, from inflation trade at similar levels. However a sudden change in inflation expectations can in some cases mean that the price of these two kinds of treasury bonds can diverge rather sharply.

An example of this kind of divergence has happened recently. The chart below compare ETFs that hold baskets of plain vanilla treasury bonds: iShares Lehman iShares Lehman 1-3 Year Treasury Bond (AMEX:SHY) and the iShares Lehman 7-10 Year Treasury Bond (AMEX:IEF) with the TIPS ETF fund iShares Lehman TIPS Bond (NYSEArca:TIP):

The chart shows a sharp divergence in September and October of 2008. What can explain this kind of divergence? Classically inflation describes an increase in the overall money supply, the presumption being that with more money chasing the same goods and services, the cost of these products will increase. But inflation also refers to a rate: the rate of increase in the price of good and services. During the two months of divergence shown in the chart above, the money supply contracted due to evaporating credit. With the price of housing falling and many commodities such as oil falling during that period, lower inflation and even possible deflation threatened.

There are just a few TIPs ETFs currently trading:

iShares Lehman TIPS Bond (NYSEArca: TIP)

SPDR Barlay's Capital TIPS (NYSEArca:IPE)

SPDR Deutsche Bank International Government Inflation Protected Bonds (NYSEArca:WIP)

From a fees and performance perspective, the two domestic TIPS funds TIP and IPE are virtually identical. Performance also closely mirrors the popular Vanguard Inflation Protected Securities mutual fund VIPSX, despite small differences in holdings and duration. VIPSX is inferior to TIP and IPE from a tax perspective.

There has been some concern that prices for TIPS ETFs, like other fixed income ETFs have diverged from net asset value (NAV) during periods of market stress. This may not impact small investors much, but of the two ETFs, we prefer TIP for this reason. It has a relatively larger asset base, greater average daily volume, and superior liquidity. The vibrant options suite in TIP is also helpful. Concern about spreads and divergence of NAV is much less a factor in quieter markets and long-term investors should have plenty of opportunity to enter and exit any of the TIPS ETFs without negative spread consequences.

SPDR's WIP is a newer ETF product, which takes the TIPS ETF concept global. WIP holds non-domestic TIPS securities mostly from Europe and Japan but also from more emerging economies such as Turkey and Israel. A primary difference here compared to the domestic TIP ETFs is exposure to foreign currency, as foreign sovereign TIPS bonds are of course denominated in the local currency. So far it appears that currency risk aside this ETF will perform much in the same was as a domestic TIPS fund like TIP, though the specific relevance of hedging international inflation for many domestic investors is not completely clear . The chart below compares the internationally focused WIP with the SPDR International Treasury Bond Fund (AMEX:BWX)

As the chart above shows, the TIPS ETF WIP has fallen more sharply than the more conventional government fund BWX. The comparison here is less perfect than the comparison of TIP and IEF above because of the distinct holdings of BWX compared with WIP.

Again, the importance of dollar strenght is relevant to considering the performance of WIP. A falling dollar boosts the returns of foreign bond portfolios. A strengthening dollar hurts these portfolios. The chart below compares the returns of the CurrencySharesEuro Trust (NYSEArca:FXE), which returns the price of the euro, and the CurrencyShares British Pound Sterling Trust (NYSEArca:FXB), which returns the price of pound sterling, during this period.

As is apparent from the chart above, in the months of September and October the euro and British pound fell sharply against the dollar, accounting for some of the fall in WIP.

Traders interested in TIPS ETFs may want to consider a hedged (or short-long) position in these funds. In terms of the charts above, a trader might decide for example that given the a possible future increase in government spending, the potential for an increase in the money supply and for inflation is not sufficiently being priced into the current market. In this case he might buy TIP and sell short an equivalent amount of IEF (or buy puts or sell calls on IEF if no product is available to short). This would be a direct bet on the direction of inflation. On the other hand, if a trader were to think that we are headed for a prolonged period of deflation, a long position in IEF combined with a short position in TIP would benefit from this view.

Though many other vehicles are often mentioned-- such as commodities, dividend-paying stock and gold, overall, there is probably no better vehicle for fighting inflation than a TIPS bond position. Historically divergence between TIPS products and conventional treasury bond products of the same maturity and duration have been transitory and can be regarded as an opportunity.