NEW YORK (Fabian Capital Management) -- Treasury Inflation-Protected Securities, or TIPS, are an interesting subset of Treasury bonds designed to protect your purchasing power from the effects of rising consumer prices. However, many investors have fallen prey to the misconception that rising TIPS prices means an inflationary environment.
TIPS are issued by the U.S. Treasury with a fixed coupon and face amount that fluctuates in accordance with changes in the rate of inflation. The most common and widely accepted inflation indicator is the Consumer Price Index.
When the Consumer Price Index is rising, the Treasury pays interest on the adjusted higher face value of the bond which creates a gradually rising stream of interest payments. This increase in coupon payments allows you to protect your purchasing power by receiving additional income when the price of goods and services is increasing.
The largest exchange-traded fund in this space is the iShares TIPS Bond ETF (TIP), which has nearly $13 billion invested in 39 Treasury inflation-protected securities. Most TIPS are issued with long maturity dates and, therefore, the exchange-traded fund TIP has an effective duration of 7.6 years. This makes its price more sensitive to changes in interest rates than a shorter-maturity Treasury fund.
In addition, because TIPS are not issued as often as typical Treasury bonds, the income from TIPS tends to be lumpy. This results in dividend income that rises and falls dramatically from month to month and can produce misleading dividend yield statistics. Right now the trailing 12-month yield on TIPS is listed at a meager 0.98%. This is calculated by summing the prior 12 months of distributions and dividing by the current share price.
The price of TIPS responds to changes in intermediate-term interest rates similar to the iShares 7-10 Year Treasury ETF (IEF) rather than inflationary pressures. The recent collapse in the CBOE 10-Year Treasury Yield has spurred investors to come pouring back into bonds and prompted TIPS to hit new 2014 highs. So far this year, TIPS have gained 5.71% amid frenzied demand for fixed-income assets.