What we talk about when we talk about TIPS

Matt explains why investors should look at Treasury Inflation Protected Securities (TIPS) and TIPS ETFs now, and what the differences are between the two.

Inflation expectations have been on the rise since before the U.S. election, but markets are now more convinced of higher inflation to come due to President-elect Trump’s talk of fiscal stimulus and tax cuts. Measured by breakevens in the Treasury Inflation Protected Securities (TIPS) market, inflation expectations for the next 10 years rose to 1.93%, the highest level since the summer of 2015 (source: Bloomberg data, as of 11/18/2016). The long decline in inflation seems to be turning, as the Consumer Price Index (CPI) climbed 1.6% year-over-year, the most in two years (source: Bureau of Labor Statistics, as of 11/18/2016). This changing environment has piqued investor interest in TIPS, and in turn, TIPS ETFs.

As the name implies, Treasury Inflation Protected Securities can help protect investors against inflation, while also providing the potential for income. The payments on TIPS are adjusted according to changes in the CPI. That means the coupon and principal payments of TIPS increase with inflation and fall with deflation.

TIPS are also valued by investors for their historically low correlation with other asset classes, which can make them a good addition to a diversified portfolio.

Among the ways to buy exposure to TIPS is directly through the government (the government sells them on TreasuryDirect.gov) or through an ETF. But here are two key points to understand before deciding whether TIPS or TIPS ETFs are right for you:

Tax implications

For a taxable U.S. investor, both the bond coupon and the inflation adjustment of TIPS are taxed as income. But the majority of the inflation adjustment is paid when TIPS mature. This creates what has been coined “phantom income”, income that is taxed in the current period but not received until a later period.

iShares offers two ETFs that invest in the U.S. TIPS market: iShares TIPS Bond ETF (TIP) and iShares 0-5 Year TIPS Bond ETF (STIP). These funds address the phantom income issue by paying out a monthly distribution that includes both the coupon income coming from the underlying TIPS held in the funds, as well as the principal adjustment for inflation. The income that an investor is taxed on in the current period is received in the current period. But paying out both coupon income and realized inflation has an interesting impact on the amount of income a TIPS ETF distributes, which leads me to my second point.

Distributions will vary

Coupon income on TIPS is generally positive, but the inflation adjustment can be positive or negative depending upon changes in the CPI. Investors should be aware that during periods of high inflation, the distribution on a TIPS ETF will likely rise, but during periods of deflation, the distribution will likely fall. It can even fall to zero if deflation is strong enough—this happened in November 2016 with the iShares TIPS Bond ETF. It is important to keep in mind that the distributions will fluctuate over time.

Below is a chart that shows the historical CPI levels and distribution yields for the iShares TIPS Bond ETF (TIP). A change in CPI doesn’t impact the inflation accrual for a TIPS bond until two months later.

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The performance quoted represents past performance and does not guarantee future results. Investment return and principal value of an investment will fluctuate so that an investor’s shares, when sold or redeemed, may be worth more or less than the original cost. Current performance may be lower or higher than the performance quoted. Performance data current to the most recent month end may be obtained by visiting www.iShares.com or www.blackrock.com. For standardized performance of TIP, please click here.

So what’s the verdict?

With the prospects of rising inflation and a potential Federal Reserve rate hike around the corner, now may be a good time to consider TIPS or TIPS ETFs. TIPS can play a role in your portfolio but be careful of the phantom income issue created when buying bonds directly. If you are investing via a TIPS ETF, be aware that the distribution on the fund will vary according to changes in inflation.

Matt Tucker, CFA, is the iShares Head of Fixed Income Strategy and a regular contributor to The Blog.

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TIPS can provide investors a hedge against inflation, as the inflation adjustment feature helps preserve the purchasing power of the investment. Because of this inflation adjustment feature, inflation protected bonds typically have lower yields than conventional fixed rate bonds and will likely decline in price during periods of deflation, which could result in losses. Government backing applies only to government issued securities, and does not apply to the funds.

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