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TIP: A Better Tool for Protecting Your Portfolio Against Inflation

By:
Chetan Woodun
Published: Dec 26, 2021, 08:13 UTC

Initially, it was a mild debate around whether inflation was to be transient or permanent, due to temporary supply chain disruptions related to the pandemic. Subsequently, these disruptions persisted and high inflation is now a top concern for investors.

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The Federal Reserve has intensified its battle against higher prices by shifting to an earlier end of its asset-buying program and signaling its desire to raise interest rates in 2022 at a faster pace than some economists were expecting.

Inflation-Protected Treasury Securities

Now, many look to protect their portfolio by investing in gold or treasury bonds, but I consider Inflation-Protected Treasury Securities (TIPS) due to the specific nature of the current threat. TIPS are issued and fully guaranteed by the U.S. government, as tools to keep up with inflation and preserve the buying power of an investment.

What brought me to this space was a glance at the iShares TIPS Bond ETF (TIP), whose one-year performance at 5.14% was much better than treasury yields as represented by the BTC iShares U.S. Treasury Bond ETF (GOVT) which delivered -2.25% (minus 2.25%). As for the SPDR Gold Trust ETF (GLD), it delivered a miserable -3.83%, dealing a blow to many including myself who have been trusting the precious metal.

https://static.seekingalpha.com/uploads/2021/12/25/49663886-16404557682266994.png
Source: Chart built through data from fxempire.com

TIP’s outperformance by such a large degree is also due to its popularity among market participants and individual investors who can purchase it just like another ETF instead of having to disburse $10K along with other fees as when investing directly in treasury bonds. The ETF is thus very liquid as an investment tool and can be traded rapidly.

Inflation, GOVT and TIP (ETFs)

Looking for reasons for the underperformances of the other two assets, I start with GOVT. In this respect, in the current low-interest-rate environment yields based on the face value of a bond or, the real yield an investor receives is negative, after accounting for rising inflation. This adversely impacts GOVT despite its basket of U.S. treasury bonds. As for gold’s underperformance, it may have lost its luster as a hedge against inflation as more investors allocate cryptocurrency assets or other precious metals like Palladium to their portfolios.

On the other hand, as for TIP, its real returns are obtained after adjusting for inflation. This is because TIPS are indexed to inflation, or more specifically the CPI (consumer price index). Hence, the difference between the nominal treasury yield and the TIPS yield is called the effective inflation rate and is a market-based measure of expected inflation.

I further substantiate my statement by showing the adjustment; or rather adjustments as there are twelve in all, in the table below. Each adjustment results in investors being paid distributions as per the schedule.

https://static.seekingalpha.com/uploads/2021/12/25/49663886-16404557682723546.png
Source: ishares.com

Here, some would have noticed that the distributions made for 2021 have been gradually increasing after being zero for the month of January. This is all due to the fact that TIP’s benchmark index is the Bloomberg U.S. TIPS Index and the latter is purely adjusted based on CPI numbers. In this case, a look at the evolution in the U.S. Inflation rate in Trading Economics shows CPI rising gradually from 1.4% in January to 5.4% in July before incrementing steeply to 6.8% in December. This explains why the distributions for the last month of 2021 have been the highest.

Now, TIPS makes sense for inflation protection due to their lower historical correlation with other asset classes. As per the U.S Department of Treasury, they have a “Deflation floor”, signifying that investors “will not receive back less than the nominal principal value at maturity”. Interestingly, the TIPS market is the world’s largest inflation-indexed securities market with over $550 billion of TIPS outstanding with an average daily turnover of over $5 billion.

Looking further at the fixed income asset class, there is also the Vanguard Short-Term Inflation-Protected Securities ETF (NASDAQ:VTIP) which comes at an expense ratio of only 0.05%, compared to a higher value of 0.19% for TIP. However, the latter’s distributions are carried out on a monthly basis compared to a  quarterly one for VTIP. Additionally, the iShares ETF has outperformed its Vanguard peer’s one-year performance of 5.07%.

To put things into perspective, the annual inflation rate in the U.S. accelerated to 6.8% in November of 2021, the “highest since June of 1982”. This is in line with forecasts and equally important, marks the 9th consecutive month the inflation stays above the Fed’s 2% target. The underlying reasons for this are rallying in global commodities prices including food, home, energy, upbeat demand for most commodities, wage going higher leading to higher cost of services like transportation, together with supply chain disruptions. These disruptions look to continue with the spread of the Omicron strain of the coronavirus.

Consequently, looking ahead to 2022, the forecast is for CPI to reach 6.9% in January and escalate to an average of 7% in Q1-2022. Economic forces of demand-supply-price should ultimately prevail and result in inflation decelerating, possibly to 3.8 percent by the end of 2022. In the meantime, bearing in mind that inflation is at its highest in the last 39 years, an investment in TIPS still makes sense, instead of gold or treasury bonds in order to protect your portfolio.

About the Author

Chetan Wooduncontributor

Chetan Woodun has a Masters in Information Management and a Post Graduate Diploma in Business Management and Industrial Administration. He is certificated in Cloud, AI, Blockchain, IoT, Equity Finance, Datacenter and Project Leadership.

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