This month's surprise Republican election sweep has prompted many investors to snap up U.S. Treasury Inflation-Protected Securities, or "TIPS" -- especially in light of President-elect Donald Trump's economic plans.
The big tax cuts and increased government spending that Trump foresees for infrastructure and the military could raise consumer prices in general, which could begin to eat away at the nominal returns of even traditionally safe investments such as Treasury bonds. That's leading to near-record inflows for TIPS-related mutual funds.
"There's a ton of demand," Eaton Vance bond manager Stewart Taylor said. "I think people are beginning to understand that the inflation trend is changing. We think TIPS [are] a pretty good way to take advantage of that."
TIPS are five-, 10- and 30-year U.S. Treasury bonds that combat yield erosion by offering automatic inflation adjustments in addition to a normal interest payout. They come with a fixed interest rate, but the bonds' par value (principal) automatically increases to take any U.S. inflation into account. The U.S. Treasury also pays you interest on this higher principal.
Taylor said all of that makes TIPS a good choice today, given that he expects the U.S. inflation rate to climb to roughly 3% to 4% in 2017 -- its highest level in years. "There's this whole confluence of events going on," Taylor said. "Services inflation [has] run at 3% for a long time, [but was] hidden by the decline in goods inflation which has probably run its course."
In addition to increased fund inflows for TIPS, the so-called "breakeven inflation rate" has also risen since the election. The breakeven rate is a measure of expected inflation that's compiled by comparing yields on "regular" 10-Year U.S. Treasury bonds with those of 10-Year TIPS. This spread hit a 2016 peak shortly after Trump's election win.
Investors who want to play TIPS can do so by buying them directly from the U.S. Treasury, purchasing them on the secondary market or investing in a wide variety of bond funds and ETFs that offer TIPS exposure. Some popular TIPS-related exchange-traded funds include the iShares TIPS Bond ETF (TIP) , the SPDR Bloomberg Barclays TIPS ETF (IPE) and the Vanguard Short-Term Inflation-Protected Securities ETF (VTIP) .
Morningstar analyst Miriam Sjoblom recommends investors consider what she calls a "very straightforward" TIPS option -- the Vanguard Inflation-Protected Securities Fund (VIPSX) . Morningstar gives this mutual fund a "Gold" rating.
But Sjoblom cautioned that while TIPS can serve as a useful inflation hedge, some caveats apply. For example, she noted that TIPS experience mark-to-market volatility that can change as investor expectations about U.S. inflation rates move.
"While TIPS don't bear the same risk of rising inflation that nominal bonds do, they still have interest-rate risk," Sjoblom said. "In the event real yields rise, TIPS can suffer price declines." She said that's particularly important to bear in mind given that real U.S. interest rates are currently very low.
Taylor said he avoids long-maturity TIPS because any unexpected spike in interest rates would hurt their yields, given that TIPS' inflation-adjustment component can lag increases to interest rates. "I don't think its appropriate to take rate risk in inflation-protected portfolio," the fund manager said. "The loss due to rising rates could be huge. If you want a pure [inflation] hedge, you buy short TIPS and you roll them over."