A TIP for Short-Term Income

11/25/2009 10:16 am EST

Focus: ETFS

Scott Burns

Director of ETF Analysis, Morningstar, Inc.

Scott Burns, Morningstar’s director of ETF analysis, finds a short-term TIPS ETF that offers inflation protection with less volatility than longer-term bonds.

PIMCO 1–5 Year US TIPS Index (NYSEArca: STPZ) is ideal for investors looking for easy and low-cost access to the short end of the Treasury inflation protected securities market.

The fund provides a laddered structure with the underlying index holding securities that range from one to five years in duration. The overall effect is an average duration somewhere in the range of 2.5 years.

The security provided by this fund is traded off by the lower returns that short-term
inflation protected securities offer. As of this report, the expected yield to maturity on the underlying portfolio was 1.75% as calculated by PIMCO.

STPZ bonds’ principal is linked to changes in the consumer price index and provides an effective hedge against inflation in an investor’s portfolio relative to standard Treasury bonds. As the consumer price index (CPI) rises, the principal in the individual TIPS bonds is adjusted upwards. The coupon on the bond is then paid on the higher principal, which raises the overall effective yield of the security.

In a deflationary environment, this adjustment manifests itself in a suspension of distributions from the fund. So investors counting on steady distributions for income should be careful using this product because, during periods of CPI deflation, STPZ will suspend distributions.

Because of the inflation adjustment on TIPS, the yield you get today is not set in stone and investors should be prepared for it to move up or down depending on the movements of the CPI.

In an asset allocation strategy, STPZ should be considered as a complement to your government bond allocation. More active investors and speculators will want to consider adding TIPS to their portfolio when they think that inflation will be higher over the next several years than is currently priced into the inflation break-even rate.

In general, we think investors should consider adding TIPS—and therefore STPZ—to their portfolios when market expectations for inflation are low. This allows investors to buy inflation insurance at a very reasonable or even cheap price. Inflation over the past ten years has been incredibly benign, averaging around 2.5% to 3.0% annually. Historically, any time the inflation break-even rate has been below that average, the investor was better off owning TIPS instead of the relative Treasury.

Since October 2008, the inflation breakeven rate has remained below its long-term average, even going negative during intraday trading.
Because this fund is at the shorter end of the maturity curve, [any] impact of the rise in real interest rates will be muted as the fund turns over its portfolio and underlying
issues mature. [That won’t] absolve this fund from all of its exposure, but it will suffer far less than TIPS bonds or funds with longer durations.

Holding TIPS in a tax-deferred account is always preferred—just as it would be for any non-tax-exempt bond fund.

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