Last Wednesday was party day for inflationists. The Bureau of Labor Statistics December’s Consumer Price Index (CPI) was posted, revealing a 12-month inflation rate of 2.1 percent.
Why the confetti and noisemakers? It was the first time the headline number has been above 2 percent since mid-2014. Even more significant was CPI’s rise above the break even inflation (BEI) rate.
The breakeven rate? That’s the spread between the nominal yield on a Treasury security and the real yield on an inflation-linked investment of a similar maturity. As of Wednesday, the 10-year Treasury note was priced to yield 2.42 percent. A Treasury Inflation-Protected Security (TIPS) with a 10-year maturity offered a real return of 42 basis points (.42 percent). The spread between these rates—2 percent or 200 basis points—fell one basis point below CPI’s growth rate.
That last occurred for 18 trading days in February. Prior to that? There was an excursion lasting nearly 300 trading days between April 2011 and May 2012. These excursions, that is whenever CPI’s annual rate exceeds BEI, favor investment in TIPS.
Why? Because the principal of a TIPS increases with inflation, measured by CPI. At maturity, a TIPS is redeemed at the inflation-adjusted value or the original principal, whichever is greater.
The question for investors now is this: Is the current excursion a temporary phenomenon, like last year’s, or a sustainable trend?
We’ve looked at the prospects for inflation in our December 16 and October 17 columns.
The odds now favor a sustainable inflation trend. You can see the stirrings of that reflected in the 12-month performance of medium-term TIPS exchange-traded funds versus an ETF tracking conventional Treasury obligations with similar maturities:
|
|
Annual Return (%) |
Standard Deviation (%) |
Sharpe Ratio |
Sortino Ratio |
Correlation To US Stocks |
Expense Ratio (%) |
|
iShares TIP |
3.34 |
4.22 |
.75 |
1.33 |
-.09 |
.20 |
|
Schwab SCHP |
3.29 |
4.26 |
.76 |
1.36 |
-.06 |
.07 |
|
Pimco TIPZ |
3.04 |
4.55 |
.64 |
1.13 |
.01 |
.20 |
|
SPDR IPE |
2.90 |
4.61 |
.60 |
1.04 |
-.08 |
.15 |
|
iShares IEF |
0.50 |
6.67 |
.08 |
.12 |
-.45 |
.15 |
If you’re looking to fill out a portfolio with a fixed income exposure, it’s wise to make some room for a TIPS allocation.
Brad Zigler is REP./WealthManagement's Alternative Investments Editor. Previously, he was the head of Marketing, Research and Education for the Pacific Exchange's (now NYSE Arca) option market and the iShares complex of exchange traded funds.