Managing interest rate risk with TIPS

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TIPs can mitigate inflation risk, but they are not immune to interest rate risk. This is how the best short duration TIP ETFs have performed.

Evolution is about looking forward. – Gerard Piqué

I find it difficult to concentrate looking ahead. So I look back. – Iggy Pop

As financial professionals, we are expected to look ahead and provide pathways for our clients. However, our success as sailors is based on our past, so it is necessary to look back. Gerard Piqué, meet Iggy Pop.

Sometimes the future is quite clear. Like a year ago when we ventured to talk about inflation. Specifically, we forecast an imminent target of 3% for the 10-year breakeven rate of inflation (EIB).

equilibrium inflation

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We hit that mark in April, and we may be heading for another 50 basis point rise before long. That being said, it looks like inflation is going to be a backdrop for more turmoil in both the equity and credit markets for some time to come.

This is where that vision of the future comes into play.

Suppose, for the moment, that inflation persists. What can a portfolio owner or manager do to protect against its ravages?

Long-term clinical evidence has shown that the most consistent bulwark has been Treasury Inflation Protected Securities, or TIPS. But TIPS are not without risk, interest rate risk to be exact. If the Fed is in a tightening mood, the market value of TIPS is vulnerable, perhaps more so than conventional Treasuries of similar maturity. It is incumbent on a prudent investor or adviser, then, to consider mitigating this risk by shortening the duration of their exposure to TIPS as much as is tolerable.

While shorter-maturity TIPS have historically exhibited less interest rate risk, they have also been better correlated with inflation. The interaction between the correlation of inflation and interest rate risk is important: shorter-dated bonds are less affected by interest rate movements and more responsive to inflation expectations. A change in inflation sentiment is most clearly reflected in the shorter-term TIPS. Short-term TIPS are less volatile than their longer-term cousins.

These characteristics are clearly evident in the table below that compares the performance of five of the shortest duration TIPS ETFs with that of the longest category giant, the iShares TIPS Bond ETF (TIP).

iShares TIPS Bond ETFs

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TIPS ETF Price Performance (May 2021 to May 2022)

ETF TIPS

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the Invesco PureBeta 0-5 Year US TIPS ETF (PBTP) offers broad exposure to the short end of the domestic TIPS market through a market-weighted portfolio of 22 securities with maturities between one month and five years. The fund is small with just $118 million under management, but it is the fastest growing short-term TIPS ETF this year, attested by positive net cash flow of $53 million to date. The fund’s 7 basis point (0.07%) expense ratio, coupled with its low duration, makes the fund attractive as a cash management tool. PBTP pays quarterly dividends and rebalances monthly.

Even lower costs, just 4 basis points, for holders of the Vanguard Short-Term Inflation-Protected Securities ETF (VTIP). Like PBTP, the $20.6 billion Vanguard fund has 22 stocks and pays quarterly dividends. Unlike the Invesco fund, however, VTIP’s growth has been the slowest in our table. While a $1.3 billion inflow so far this year seems big, it only represents 6% of the fund’s current assets.

It’s rare that Vanguard is outperformed on the cost front, but the iShares 0-5 Year TIPS Bond ETF (STIP) offers short-term TIPS market coverage at a minimum annual expense of just 3 basis points. STIP’s $11.9 billion portfolio is populated by 20 stocks and looks a bit heavy with 77% of its weight concentrated in ten issues. This year, inflows have risen to 28% of the fund’s current size.

What sets the $1.5 billion apart PIMCO 1-5 Year US TIPS Index ETF (STPZ) Papers with less than 12 months of maturity are excluded from the previously considered portfolios. STPZ’s portfolio of 21 issues is even more concentrated than STIP’s. 82% of the PIMCO ETF’s assets are parked in its top ten issues. At 20 basis points, STPZ is also the most expensive fund in our table. PIMCO’s fund has grown $208 million this year, representing 14% of its asset base.

Finally, there are the 2,100 million dollars FlexShares iBoxx 3-Year Target Duration TIPS Index Fund (TDTT) which is approaching the TIPS market with a very specific mandate: maintain a weighted average portfolio duration of three years. TDTT’s managers accomplish this by investing in a mix of TIPS with maturities ranging from one to 10 years, though most of the heavy lifting is done with stocks with less than five years to run. Derivatives may be used from time to time to steer the portfolio towards its objective. Investors pay 18 basis points per year to hold TDTT. Inflows this year represent 33% of the size of the fund.

conclusion

Obviously, the main motivation to invest in TIPS is to protect against corrosive inflation, but keeping duration low while the Fed is in a combative stance is where the benefit accrues best. Apparently, this notion is resonating with investors, as evidenced by the turnover in the TIPS market. This year, the iShares TIP fund has seen a net outflow of $4.5bn, while our table of five short-term TIPS ETFs have collectively raised $5.6bn in net new assets.

Low duration TIPS ETFs are likely to benefit from rising inflation and more Fed tightening, at least compared to longer-dated paper-laden funds. Our table provides investors and their advisers with products that offer the highest possible correlation to future inflation expectations.

Take THAT, Iggy Pop.

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Editor’s note: The summary bullets in this article were chosen by the editors of Seeking Alpha.

Source: news.google.com