With massive stimulus programs currently getting geared up, along with related record-ripping government borrowing, does an average inflation rate of just one percent over the next ten years sound plausible? Maybe not, but that’s precisely what the current yield spread between ten-year Treasuries (2.93%) and ten-year Treasury Inflation Protected Securities (TIPS) (1.87%) would imply.
While nobody can pick market price or interest rate tops and bottoms, there are a few things that we can “know” with relative certainty: Over the next several years borrowing by the U.S. government will be of historic proportions and will exert upward pressure on interest rates. Meanwhile, the gaining of traction by tsunami-sized economic stimulus programs will translate into a significant source of demand for commodities and raw materials, as well as for goods and services overall.
Exposure to commodities as demand recovers can help cushion the effects of a potentially forceful inflationary wave rippling through the economy. But there’s an additional important tool that can be deployed to help further protect against the ravages of inflation: Treasury Inflation Protected Securities.
TIPS are designed to protect principal while ensuring a return above the rate of inflation, using the Consumer Price Index (CPI) as the measure of inflation.
The two primary elements of TIPS are a) periodic payments of a fixed rate of interest against a principal amount that is b) adjusted according to change in the CPI. As inflation goes up, for example, so does the principal value against which interest payments are calculated. At maturity, the holder gets the higher of the CPI-adjusted principal level and the original issue principal or “par” value. Being indexed against a relatively broad measure of inflation, TIPS can serve as an important inflation-cushioning complement to commodity holdings. Unlike commodities, though, TIPS also generate current income.
In the near term, the risk of deflation (or falling prices) is still a real risk to the economy and to the performance of TIPS. Each passing day, though, brings us closer to implementation of demand and inflation-driving stimulus programs and related interest rate pressures from exploding government borrowing programs.
Fortunately, there are currently two ETFs that provide investors with low-cost, diversified exposure to TIPS. iShares TIP provides exposure to U.S. TIPS with a yield currently slightly above 2% and an average maturity of just under nine years (Barclays TIPS Bond Fund). StateStreet’s WIP, with a yield of slightly less than 2.5%, provides exposure to international TIPS (SPDR DB International Government Inflation-Protected Bond ETF). StateStreet also has a global TIPS ETF currently in registration, awaiting SEC approval.
In general, and certainly against the current economic backdrop, TIPS (in combination with commodities) can play an important diversification role in investment portfolios.
