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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