Why TIPS Are The Best Fixed Income Option In The Market Today

David Dierking

The global economic slowdown along with the Fed's zero interest policy have created precious few opportunities for fixed income investors to obtain anything resembling a reasonable yield.

The 10-year Treasury rate is around 0.6%. 5-year CDs pay about the same. Money markets yield next to nothing. Short-term investment-grade corporates are modestly higher at around 1%, but then you're looking at junk bonds, REITs, utility stocks and other riskier securities. Those could sell off quickly if the COVID outbreak grows and shuts additional areas of the economy.

But yield isn't the only consideration. It may not be an immediate worry to many investors in the current environment, but inflationary risks are growing.

It used to be that investors viewed the economy as an all or nothing proposition - if COVID spreads rapidly, shut down businesses to discourage social gatherings, but if the curve flattens or declines, keep things open.

Today, the U.S. appears to be trying to take a blended approach - keep the economy open, while encouraging mask wearing as a means of flattening the curve. It's a risk, for sure, and could be the strongest case yet for higher inflation coming soon.

The Case For TIPS

If you're a believer that inflation is on the way, Treasury Inflation Protected Securities, or TIPS, is the way to go. In comparison to other fixed income products, I believe it's the best option to not only protect against rising consumer prices, but also to produce gains in your portfolio in a difficult environment.

First, let's take a look at the state of inflation in the current economy.

IUSCCPCEPIY_chart

The Fed's preferred inflation measure is the Personal Consumption Expenditure Index. As you can see, over the past quarter century, this measure has rarely exceeded the Fed's 2% target and often comes well short it. This is important to note because the PCE is usually lower than the more commonly accepted inflation and core inflation rates.

IUSCCPCEPIY_IUSIR_IUSCIR_chart-2

The inflation rate, which includes more volatile food and energy prices, tends to bounce around more frequently, but you can see that it's been in that 2.0% to 2.5% range for most of the past decade.

Same with the core rate, which excludes those two factors. It's also remained in that 2.0% to 2.5% range (up until recently, of course).

The Fed Will Let Inflation Run Hot

The fact that the Fed's preferred inflation measure understates the more commonly used measures by about 0.5%, you run a significant risk of above average inflation on that notion alone.

But what happens when the Fed is about to let inflation run hot on top of that?

There's this article from Bloomberg along with the following caption:

Screen Shot 2020-07-21 at 7.42.27 AM

This has been discussed by the Fed for more than six months. The ideas was originally floated as a way to allow the global economy to avoid what looked like an impending recession, even pre-COVID. Obviously, that recession is here now for other reasons, but it perhaps reinforces the notion of the Fed's desire to let prices run higher.

In my opinion, the Fed is setting up the economy for a scenario that allows inflation to spiral out of control.

The Possibility of Hyperinflation

More investors appear worried about the idea of deflation instead of inflation, but that's likely just a short-term view.

fredgraph-3

We've seen inflation expectations fall significantly earlier this year as the COVID threat grew, but has since been steadily rising. The breakeven inflation rate still isn't even at the 1.5% level, so it's not a large-scale worry at the moment.

But think about all of the factors in play right now that could lead to higher inflation.

  • Record low interest rates
  • Trillions of dollars of stimulus with more to come
  • Retail sales back at pre-COVID levels
  • Fed willing to allow above average inflation

Consumers spending money like it's a normal economy armed with thousands of stimulus dollars and the ability to borrow at rock bottom interest rates? And the Fed making little effort to control any corresponding price increases? Sounds like a recipe for hyperinflation.

TIPS Are Already Outperforming

Even though they don't get a lot of attention, TIPS have been performing very well in 2020 and are indicating that investors are more worried about inflation than the headline numbers may be letting on.

IUSCCPCEPIY_IUSIR_IUSCIR_TIP_TLT_IEF_SHY_chart

You'll never see TIPS outperform long-term bonds during a Treasury bull market like the one we've been in lately, but they have been steady performers producing solid gains while exposing investors to limited risk.

Coming out of the bear market bottom, TIPS have, in fact, been steadily outperforming intermediate-term Treasuries for about four straight months.

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Investors have been bidding up TIPS prices already and the ETF market shows noticeable inflows into many of these products.

Top TIPS ETFs

So how would you play this in your portfolio? There are several highly rated, low cost TIPS ETFs to choose from.

  • iShares TIPS Bond ETF (TIP)
  • Schwab U.S. TIPS ETF (SCHP)
  • SPDR Portfolio TIPS ETF (SPIP)
  • Vanguard Short-Term Inflation Protected Securities ETF (VTIP)
  • iShares 0-5 Year TIPS Bond ETF (STIP)

If you're looking for yield, TIPS aren't going to help you out much. Like other Treasuries, the yields are mostly less than 1%, but it's the total return potential in a high inflation environment that's the real appeal.

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