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TIPS May Not Be the Best Hedge Now Against Rising Inflation

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Inflation is rising and the Federal Reserve is getting read to raise rates again. All good reasons to buy securities like Treasury Inflation Protected Securities that hedge against rising rates, right? Not necessarily.

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Much of the good news about TIPS, like stocks, may already be discounted in the market because the underpinnings of expectations for rising inflation, such as massive infrastructure spending and broad-based tax reform by the new White House administration, appear less certain today than late last year.

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“TIPS have seen a pretty good rally recently relative to Treasuries,” says Brett Wander, chief investment officer, fixed income, at Schwab. “But a lot of the recent outperformance [of TIPS] has been based on expectations that Trump can deliver on his growth initiatives: fiscal spending, lower taxes and less regulation.… We’ve seen some, but very few meaningful indicators of higher inflation.”

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“Virtually no one we talk with thinks there will be much progress on this issue in 2017,” wrote Greg Valliere, chief global strategist at Horizon Investments, about a federal infrastructure program in a recent edition of his Capitol Notes. “Don’t expect an effective date on tax cuts before Jan. 1, 2018.”

That wasn’t the expectation in the market just months ago. Morningstar’s TIPS fund category, which includes mutual funds and ETFs, gained 0.89% for the three months ended Feb. 17 while the long and intermediate-term government bond categories fell 0.30% and 0.23%, respectively.

Over the past 12 months, TIPS funds gained 5.23% when long-term bond funds lost 4.34% and intermediate funds slipped 0.27%, according to Morningstar.

But now “inflation appears to be climbing slowly,” wrote Bob Doll, chief equity strategist at Nuveen Asset Management, in his latest market note.

Inflation, however, is still rising. The latest government report shows the consumer price index running at an annual rate of 2.5%, its highest in four years.

Given that rate, “a 10-year TIPS looks like a good buy on the face of it,” says Morningstar analyst Brian Moriarty, but it might not be. He explains that the breakeven inflation rate on 10-year TIPS — which is the difference between the yield on a nominal fixed-rate Treasury and the real yield on an inflation-linked bond of similar maturity — is currently at 2.06%, which indicates that a 10-year TIPS will outperform the nominal Treasury only if inflation averages more than 2.06% over the next 10 years.

That’s certainly possible but not guaranteed, especially since the long-term historical breakeven average is roughly 2% for the 10-year Treasury, according to Moriarty. He recommends that in general investors buy TIPS when they’re trading below their long-term historical breakeven average, which is especially important if they’re buying TIPS for the short term.

That was clearly the case early last year when the 10-year TIPS could be purchased with a breakeven at 1.2% — “almost comically low,” says Moriarty, but that’s not the case now, when the breakeven is near the historical average. When that happens there is really no difference between TIPS and a regular Treasury, he adds.

He says investors need to know why they’re buying TIPS and that longer term TIPS are more correlated to changes in inflation expectations over the term of the security while short-term TIPS are more closely correlated to monthly changes in inflation, as measured by the CPI.

Bryce Doty, a senior portfolio manager with Sit Fixed Income Advisors, says TIPS are not a good buy now because of recent statements from Fed Chair Janet Yellen suggesting that the central bank would be better off raising rates sooner than later. (In recent congressional testimony  she said it “would be unwise” for the Fed to hold off too long on a rate increase.) Minutes of the latest meeting of the FOMC, the Fed’s policymaking committee, released Wednesday, suggest a rate hike “fairly soon.”

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“The more aggressively the Fed raises rates, the more likely it is that investors begin to reduce their inflation expectations, which would be very costly to TIPS investors,” says Doty.

He noted that after the unexpectedly high inflation numbers of the last CPI report, TIPS were “essentially flat” even though they outperformed traditional Treasuries, whose prices fell as yields rose.

Rather than buy TIPS now, he suggests that investors short U.S. Treasuries futures as a way to hedge bond portfolios against rising rates.

Sit’s rising rate ETF, RISE, does that aggressively as a fund with a negative 10-year duration. Since duration is a measure of a portfolio’s sensitivity to interest rate changes, RISE is designed to gain substantially when rates rise, but it will lose value when rates decline. RISE is a “natural hedge” for TIPS and other fixed income investments, says Doty, who oversees $7.3 billion in fixed income assets. The $14 million ETF has an expense ratio of 1.5%.

That’s too rich for the blood of Todd Rosenbluth, director of ETF and mutual fund research at CFRA.

“It’s hard to see the merits of paying that much more than you would for TIP [iShares TIP fund], which charges 20 basis points, or VTIP [Vanguard’s short-term TIP fund], which charges 10 basis points.”

Both of those funds are more sensitive to interest rate changes than RISE, however, with positive durations of 7.5 and 2.7, respectively. Other investment options are interest-rate hedged investment grade bond funds from ProShares, Deutsche Bank and WisdomTree and iShares, some with zero duration, which will neither rise or fall in price as a result of changing interest rates.

Doty suggests that investors include RISE along with TIPS and even floating-rate ETFs as part of a larger strategy to reduce a portfolio’s interest rates risk and dampen volatility.

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