For the first time in several years, inflation is becoming a genuine concern that investors need to worry about. That's not to suggest that inflation rates are about to begin skyrocketing, but certain segments of the economy are already showing notable price increases and the Treasury yield curve is reflecting those risks.
The 5-year breakeven rate, a measure of forward-looking inflation expectations, is at its highest level since 2012.
Higher inflation expectations often manifest themselves in the Treasury yield curve. That's exactly what we've been seeing throughout the first two months of 2020 as the 10-year Treasury rate, which started the year as low as 0.9%, just eclipsed the 1.5% level this past week.
Part of that rise in interest rates could be the expectation for an economic recovery later this year, but I think inflation is the primary factor for what we're seeing here.
Investors have already been adding inflation protection to their portfolios throughout the past year as TIPS have been the top-performing category of the government bond market. TIPS are down about 2-3% year-to-date, but that's much better than the -11% returns from long-term Treasuries.
TIPS probably belong in just about every portfolio in some allocation, but now might be an ideal time to consider adding some exposure. According to the ETF Action database, there are 16 TIPS ETFs available in the marketplace. Given the negative real yields out there today and the increased volatility in the Treasury market, targeting ETFs with ultra-low expense ratios is especially important. Also worth considering is whether you want to zero in on ETFs focused on short-term TIPS or the broader TIPS market because that will affect how much volatility you'll see in these investments.
Inflation protection, however, is the key in owning TIPS. These are five of my favorite TIPS ETFs.
Schwab U.S. TIPS ETF (SCHP)
Like many ETFs in the Schwab lineup, SCHP is the cheapest in this space, charging just 0.05% annually, and covers the entire range of TIPS maturities.
The "short-term vs. long-term" debate should be a deciding factor in which ETF you should consider choosing. Because it targets longer maturity notes, it comes with higher volatility and a higher portfolio duration. That can mean trouble in a rising rate environment like the one we're currently in. Year-to-date, funds like SCHP are underperforming shorter-term focused TIPS funds by around 250-300 basis points. Most of that is due to changes in interest rates.
From a structural standpoint, this is one of the best TIPS ETFs you'll find. It's big, it's liquid, it's cheap and it has a solid long-term record.
Vanguard Short-Term Inflation Protected Securities ETF (VTIP)
VTIP is essentially the shorter-term version of SCHP and it's just as cheap. Also charging just 0.05%, it provides similar inflation protection, but will typically experience much less volatility in the process.
Making a choice between funds, such as VTIP and SCHP, could depend on where you think interest rates are headed. These are Treasury notes after all and will rise and fall based on how interest rates move. Interest rates and inflation expectations are often correlated, so choosing a fund like VTIP could take some risk off the table.
iShares 0-5 Year TIPS Bond ETF (STIP)
This is pretty much the iShares version of VTIP. Like the other two funds already listed, it also has a 0.05% expense ratio and comes with a similar portfolio composition to Vanguard's ETF. The only real distinction right now is that STIP comes with a very slightly higher yield at the moment, but outside of that, they're substantially similar to each other.
SPDR Portfolio TIPS ETF (SPIP)
SPIP targets TIPS of all maturities making it more similar to SCHP than the others. With a portfolio duration of more than 8 years, it rates as one of the most interest rate sensitive ETFs in this category. With an expense ratio of 0.12%, it's slightly more expensive than the other ETFs already discussed, but it's not a dealbreaker by any means.
iShares TIPS Bond ETF (TIP)
TIP is the oldest ETF in this group, having launched all the way back in 2003, and the largest with assets of more than $27 billion. Unfortunately, it's also one of the pricier ones with an expense ratio of 0.19%. That's enough of a difference to potentially tip the scales in favor on a fund like SCHP, which provides a substantially similar portfolio for 1/4 the price.