A Tip: Buy TIPS

11/26/2008 10:00 am EST

Focus: BONDS

Scott Burns

Director of ETF Analysis, Morningstar, Inc.

Scott Burns of Morningstar ETFInvestor says investors are ignoring future inflation, so he thinks Treasury inflation-protected securities (TIPs) are a good deal now. 

Inflation may have abated for now, but given how the government has been freely printing money to rescue the financial system and the economy, we don’t expect that to be the case for too much longer. For long-term investors deciding between buying Treasuries or buying Treasury Inflation-Protected Securities (TIPS), the answer is clear: Buy TIPS.

IShares Lehman TIPS Bond ETF (NYSEArca: TIP) is ideal for investors looking for easy and low-cost access to TIPS. The fund provides a laddered structure with the underlying index holding securities that range from one year to 20 years in duration. The overall effect is an average duration somewhere in the range of 6.5 to 7.25 years.

TIPS’ 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 is adjusted upward. The coupon on the bond is then paid on the higher principal, which raises the overall effective yield of the security. (The inflation adjustment does swing both ways, though, so any decrease in the CPI will result in a decrease of TIPS principal.)

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

In general, we think investors should consider adding TIPS—and therefore iShares Lehman TIPS—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, depending on your measuring stick. So, historically, any time the 10-year inflation break-even rate has been below that average, the investor was better off owning TIPS instead of the relative Treasury at the time.

As of October 2008, the inflation break-even rate was at its lowest point in nearly ten years. During the credit meltdown, the TIPS spread has hovered below 1% and even gone negative during intraday trading. We think this means that investors should prefer to own TIPS bonds over plain-vanilla Treasury bonds, and the iShares Lehman TIPS bond is a great vehicle for gaining access to the market. (This ETF is very inexpensive. Its 0.20% expense ratio makes it compelling in both relative and absolute terms.)

(TIP closed at $92 Tuesday—Editor.)

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