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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 break-evens 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… 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… This changing environment has piqued investor interest in TIPS, and in turn, TIPS ETFs.
The comments above and below are excerpts from an article by Matthew Tucker, CFA (BlackRockBlog.com) which may have been edited ([ ]) and abridged (…) to provide a faster & easier read.
…TIPS:
- can help protect investors against inflation, while also providing the potential for income.
- payments are adjusted according to changes in the CPI…[which] means the coupon and principal payments of TIPS increase with inflation and fall with deflation…[and]
- 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.
- can be bought directly through the government (the government sells them on TreasuryDirect.gov) or through an ETF.
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Here are two key points to understand before deciding whether TIPS or TIPS ETFs are right for you:
1. 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:
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.
…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.
2. 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.
(Click on image to enlarge)
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…
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.
Disclosure: The above article has been edited ([ ]) and abridged (…) by the editorial team at 
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