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Hot TIP for ETF Investors

Morgan Stanley rolls out an exchange-traded fund based on the inflation-indexed Treasury.

Morgan Stanley


has a few TIPS for exchange-traded fund investors.

The investment bank is out this week with a research note highlighting the pros and cons of the

iShares Lehman TIPS Bond


ETF, which tracks the well-known Treasury inflation protected securities, or TIPS. The report comes on the heels of rising worries about inflation.

TIPS are designed to protect investors from the erosion of purchasing power that rising inflation can cause. In an inflationary environment, TIPS tend to outperform most traditional fixed-income investments. TIPS pay a semiannual coupon, and their par value is adjusted to account for changes in the consumer price index.

The TIP exchange-traded fund is slightly different from the underlying bonds, however, in that it pays monthly income equal to its earned coupon income plus or minus any changes made to the par value of its holdings as a result of changes in the CPI.

Like all ETFs, the TIP trades very much like a stock, in this case on the


. Options are available to be bought and sold on it as well. The expense ratio for the ETF is 0.20%.

"In light of recent commentary from the

Federal Reserve Open Market Committee

regarding increased worries about the inflation outlook, we believe it is appropriate to revisit the iShares Lehman TIPS fund," said Paul Mazzilli, ETF strategist at Morgan Stanley.

Prices rose 0.2% in November's CPI report, which was a less threatening pace than the 0.6% spike in October. Nevertheless, November's CPI reading was still 3.5% higher than a year ago, which is likely what prompted the Fed to issue its warning at its last meeting. The December CPI is set for release on Jan. 19.

In addition to the enhanced coupon payment based on the inflationary environment, Mazzilli points out that the TIP ETF should outperform traditional fixed-income investments during periods of rising interest rates.

"Rising interest rates are typically characterized by rising inflation and the protection offered through TIP through higher dividends should enable the performance of TIP to compare favorably," says Mazzilli, who cautions investors that the TIP could also decline if long-term interest rates rise.

Long-term interest rates have been expected to rise since early 2004, as the Fed embarked on its campaign of measured rate increases. Nevertheless, apart from a spike in the spring of 2004, the yield on the benchmark 10-year Treasury bond has stayed 4% and 4.3% since the beginning of 2004. Yields rise as bond prices fall, and vice versa.

Investor awareness in TIPS has grown substantially over the past year as financial advisers have increasingly attempted to prepare their clients for a potential spike in inflation. The increased interest in TIPS has led many analysts, including Mazzilli, to note that the inflation-fighting bonds might potentially be overvalued; this would be a negative for investors interested in diving into the TIP market now.

"While valuations have improved recently, our interest rate strategists believe 10-year TIPS remain slightly expensive," says Mazzilli. "As of Jan. 6, the implied break-even rate of inflation was 255 basis points for the 10-year TIPS, which is above our current inflation forecast."

The difference between comparable maturity Treasury and TIPS yields is viewed as the break-even inflation rate.

Despite concerns about overvaluation, Mazzilli notes that the TIP can be useful for investors who wish to maintain a position in inflation protected securities without going to the expense of buying individual TIP bonds.

"Buying individual bonds can be quite expensive for investors," says Mazzilli. "And it is often difficult to build and maintain a diversified portfolio of bonds unless considerable resources are allocated to the asset class."