Bond ETFs: Hedging against Inflation with TIPS - dummies

Bond ETFs: Hedging against Inflation with TIPS

By Russell Wild

Either the iShares Barclays TIPS Bond Fund ETF (TIP) or the very similar SPDR Barclays Capital TIPS ETF (IPE) is a fabulous way to hedge your bond portfolio against inflation.

Technically, U.S. Treasury Inflation-Protected Securities (TIPS) are Treasurys, but they are usually referred to as TIPS. They play a distinctly different role in your portfolio.

The gig with TIPS is this: They pay you only a nominal amount of interest (currently long-term TIPS are paying about 2 percent), but they also kick in an adjustment for inflation. So, for example, if inflation is running at 3 percent, all things being equal, your long-term TIPs will yield 5 percent.

If you want to know what the rate of inflation is going to be over the next few years, look at what rate of inflation the bond market expects. That would be the difference between conventional Treasury bonds and TIPS.

If, for example, a 10-year conventional Treasury bond were paying 5 percent and the 10-year TIP security were paying 2 percent, the difference (3 percent) would be the rate of inflation that bond buyers collectively expect to see.

If you are going to hold TIPS in your portfolio, iShares Barclays TIPS Bond Fund (TIP) is a solid choice:

Indexed to: The Barclays Capital U.S. Treasury Inflation-Protected Securities Index. The fund uses a representative sampling of roughly 30 bond issues.

Expense ratio: 0.20 percent

Current yield: 2.01 percent + adjustment for inflation

Average weighted maturity: 8.9 years

TIPS belong in your portfolio, and this fund may be the best way to hold them. You won’t get rich off this fund, and the volatility may be more than you like. But if inflation goes on a tear, you are protected. Not so with other bonds.

Of course, if inflation doesn’t go on a tear, your money will earn sub-par returns. But that’s okay — you can think of any lost interest as the premium on an insurance policy that you know you should have.

Note that TIPS are notoriously tax inefficient, even when held in an ETF. Ideally, you would hold your shares of TIP in a tax-advantaged retirement account. In general, whatever your overall allocation is to fixed income (excluding short-term cash needs), perhaps one-quarter to one-third of that amount could be put into a fund such as TIP or IPE.

Err more toward one-quarter if you have a fairly aggressive portfolio. Err more toward one-third if you have a more conservative portfolio. Rationale: Your stocks are also, historically speaking at least, a good hedge against inflation. The more stocks you own, the less important the role of TIPS.