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.
If the 2013 interest rate backup taught us anything, it's that a TIPS is not an effective tool at fighting rising Treasury bond yields in an environment of low inflation. Instead, it can be used as a directional bet on falling interest rates or as a potential income accelerator when the Consumer Price Index is trending higher. With relatively tepid CPI statistics over the last decade, TIPS has yet to show its true colors during a period of deteriorating purchasing power.
We would not likely see a dramatic increase in the yield of TIPS without inflation breaking out above this long-term sideways trend. While there is some evidence that we are witnessing rising food and energy costs this year, the CPI has yet to reflect a confirmation that inflation is running above average.
ETF income investors should be wary that in a low-inflation environment you give up substantial yield by investing in TIPS above a comparable Treasury or investment grade bond fund. This is because the "inflation insurance" component acts as a drag on the distribution yield of the fund.
At the moment I do not have any exposure to TIPS for my income clients because I don't believe the current environment is supportive of an inflationary hedge. I would rather be positioned in fixed-income sectors that are continuing to provide a higher yield with an eye towards managing interest rate risk.
The Pimco Income Fund (PONDX) and DoubleLine Total Return Fund (DBLTX) are two actively managed funds that have been core holdings of mine for some time. In addition, I have a tactical position in the iShares J.P. Morgan USD Emerging Markets Bond ETF (EMB) as a diversified value play outside the U.S.
I plan on expanding or collapsing my fixed-income sleeve in response to changes in interest rates or credit spreads as a function of risk management. I also plan on keeping a close eye on inflationary statistics in the event that a fund like a TIPS warrants a closer look down the road.
At the time of publication the author had a position in EMB.
This article represents the opinion of a contributor and not necessarily that of TheStreet or its editorial staff.
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