TIPS ETFs In A Sweet Spot: Here's Why

TIPS ETFs are in good shape right now, with Quadratic Interest Rate Volatility and Inflation Hedge ETF IVOL, iShares Inflation Hedged Corporate Bond ETF LQDI, SPDR Portfolio TIPS ETF SPIP and PIMCO Broad U.S. TIPS Index Fund (ASX:TIP) have been rallying in the past week. These funds have added in the range of 1.7% to 3.85 in the past five days (as of Mar 5, 2020).

Investors injected nearly $500 million into BlackRock Inc (NYSE:BLK).’s $22-billion iShares TIPS Bond ETF (ASX:TIP) , which tracks inflation-protected securities, on Mar 3, according to data compiled by Bloomberg. The cash inflows were the highest since April 2015 and followed the Fed’s hefty emergency rate cut. Since Fed rate cut, TIP added about $882.03 million in assets (as of Mar 5, 2020) (read: Emergency Fed Cut Less Effective: ETFs That Should Survive).

Notably, the U.S. central bank cut the target range for its federal funds rate by 50 bps to 1-1.25% during an emergency move on Mar 3, addressing the possible economic fallout owing to the coronavirus outbreak. It was the first emergency rate cut since the 2008 financial crisis.

Inside Rising Inflation Expectations

Investors should note that the expected slowdown in economic activity amid the virus threat will be caused by supply shocks— the absence of goods and services amid virus-led decline in productivity, city lockdowns, factory shutdowns and restrictions on travel.

Policy easing is less likely to help such issues as government and central bank measures are normally meant to boost demand. Amid unchanged demand, supply shocks are likely to reduce output and increase inflation. In any case, the U.S. economy had been on a firm footing before the virus issue.

Annual inflation rate in the United States jumped to 2.5% in January of 2020 from 2.3% in December, beating market forecasts of 2.4%. It marked the highest rate since October of 2018, mainly boosted by a 12.8% uptick in gasoline costs. The PCE price index rose 1.7% year over year in January, after a downwardly revised 1.5% gain in the previous month.

Great Time for TIPS ETFs?

TIPS ETFs offer robust real returns during inflationary periods unlike its unprotected peers in the fixed-income world. These securities pay an interest on an inflated-principal amount (principal rises with inflation) and when the securities mature, investors get either the inflation-adjusted principal or the original principal, whichever is greater. As a result, both principal amount and interest payments will keep on increasing with rising consumer prices.

This mechanism has made TIPS ETFs investors’ darlings in recent times as they are increasingly betting on inflation-protected bond funds. Though the expected trend of inflation depends a lot on the movement of energy prices, investors with a long-term view can count on the potential uptick in inflation as the U.S. economic backdrop appears more stable than before(read: TIPS ETFs Likely to Benefit From Fed Meeting).

If this was not enough, OPEC agreed on a huge fresh output cut — 1.5 million bpd — on Mar 5, but the deal depends on Russia’s buy-in to the cuts, two Reuters sources said. However, no development on the oil front is confirmed yet.

The above-mentioned factors boosted demand for TIPS ETFs which dragged yield down. The real yield on 10-year Treasury Inflation-Protected Securities traded near a negative 48 basis points on Mar 4, 2020.

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