A TIP for Inflation-Protection

11/24/2016 8:00 am EST

Focus: STRATEGIES

David Fabian

Managing Partner, FMD Capital Management

The bond market was rocked by quickly steepening yield curve following the election results; as a result, we must now focus on the relative value creation in high quality bonds because of the sell-off, asserts David Fabian, editor of the Flexible Growth & Income Report.

With the landscape changing, we now need to be open to the possibility of a countertrend rally, or at least stabilization in longer duration government bonds.

Remember that the best time to invest in high quality bonds is when rates have risen, since yields are not only higher, the potential for capital appreciation greatly increases.

We like to take a strategic approach to intermediate-term fixed-income holdings. Looking at our available options, we believe that Treasury Inflation Protected Securities (or TIPs) makes the most sense at this juncture.

For those that may not be familiar with TIPs, they are Treasury securities with a special inflation component that is linked to the consumer price index.

Which means, when the cost of commonly purchased goods is on the rise, so is the adjusted coupon of TIPs bonds.

Beyond that, they react similarly to changes in interest rate of nominal fixed coupon Treasury Bonds, and are of course backed by the full faith of the U.S. Government.

We successfully utilized a closed-end fund for our last round of TIP sector exposure with a tactical (short-term) investment mandate.

For our model portfolio we recommend a 5% position in the Schwab US TIPS ETF (SCHP), a low-cost and transparent exchange-traded fund as a follow-up holding.

SCHP has recently sold off alongside virtually all Treasury Bonds, which provides a unique entry point for a new holding.

In addition, SCHP and all TIPS bonds are exhibiting much higher relative strength versus municipal, investment grade corporate and conventional Treasuries on this dip.

We believe this could indicate a meaningful shift away from nominal coupon bonds into TIPS as we find ourselves in a rising interest rate environment along with a ramp-up in inflation expectations.

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By David Fabian, Editor of the Flexible Growth & Income Report

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