Has anything good come from inflation? Well, at least for the moment, you can grab yields just above 12% from ETFs that aim to fight inflation.
That clearly tops the diddly interest rates paid by savings accounts, checking accounts and miscellaneous money market funds and certificates of deposit (CDs).
The most generous rate on a five-year $25,000 CD listed by Bankrate.com, for instance, is 2.6%, going into Thursday.
Those yields of 12% and up are offered by a handful of ETFs that feast on TIPS, or Treasury Inflation-Protected Securities. The trouble is, those yields probably won't last long. So, should you dive in now, while their yields are sky high?
Inflation Fighting TIPS
The Treasury issues TIPS. The purpose of these bonds is to protect investors from high inflation. They do that by adjusting their principal based on the rate of inflation. When inflation rises, that principal rises. When inflation declines, that principal declines.
And as virtually everyone knows, inflation has been soaring. In April the annualized rate hit 8.3%. It was 8.5% in March.
Inflation pumps up the principal of TIPS. In turn, that increase is converted into higher coupon payments by the bonds. That adds to the income that ETFs holding the bonds pay out. You see that in the form of higher yield.
ETFs that invest in TIPS pass that inflation adjustment through to shareholders as income because that's what IRS rules require, says Karen Veraa, head of iShares U.S. fixed income strategy.
ETFs That Do The Job
Two funds that invest in TIPS are iShares 0-5 Year TIPS Bond ETF and iShares TIPS Bond ETF.
A third ETF that fights inflation by buying TIPS is Schwab U.S. TIPS ETF.
Investors in individual TIPS only get the principal adjustment. They do not get any conversion of that into income.
How much income are we talking about? The TIP ETF's SEC yield was 12.36%, going into Thursday. STIP's SEC yield was 12.2%. SCHP's SEC yield was 15.31%.
And why aren't those yields down around 8.3%, matching the latest annualized inflation rate? Mainly because yield reflects the latest monthly rate of increase in inflation, not the absolute inflation rate itself. And that latest monthly change "was higher than the average monthly increase over the past year, so the recent SEC yield is higher," Veraa said.
Yield also reflects management fees and bond amortization.
Good News For The Inflation Fight
The good news for funds investing in TIPS and their shareholders is that their yield should continue to rise in the near term. That's because of the lag time that can be built into ETF yield.
Take those two iShares funds. "The bonds in the ETFs just finished adjusting for the March inflation rate (1.3%)," Veraa said. "In June they will begin adjusting for the April monthly change (0.6%). The SEC yield reflects the past 30 days of income."
The inflation measurement is by the Bureau of Labor Statistics. It uses the non-seasonally adjusted U.S. consumer price index (CPI).
May's inflation rate is scheduled to be announced on June 10.
Yields will continue to rise as inflation adjustments that occurred so far this year become part of upcoming ETF distributions.
But at some point, the inflation rate will stop rising. "When the rate of monthly change stops climbing, even if the absolute rate of inflation is high, then the SEC yield will subside," Veraa said.
Another potential downside to TIPS ETFs is volatile total return. STIP is near breakeven, with a 0.02% setback this. But TIP is down 6.15%. SCHP is down 6.09%. "TIPS total return year-to-date has been negative as real interest rates have increased with inflation," Veraa said. "TIPS generally have positive returns and higher yields if inflation rises, but real interest rates are not rising as fast. Real interest rates are the interest rates adjusted for the impact of inflation and are correlated with economic growth."
How To Pick A TIPS Fund
How can you decide which ETF better suits your needs? Comparison shop. Effective duration, effective maturity, expenses and fees vary among funds, says Lawrence Pon, of the CPA firm Pon & Associates.
Duration refers to bonds and funds sensitivity to interest rate changes. The higher a bond's duration, the more the bond's price will change when interest rates move.
Generally, when inflation and rates threaten to rise, investors prefer TIPS ETFs with shorter maturities. That way, their fund has room for newer TIPS if rates rise more, Veraa says.
And figure out if you'll need to liquidate some or all of your ETF for cash at a time when it may be losing value.
Buy TIPS Directly?
One additional point about TIPS: Why not buy TIPS directly yourself? Or their kissing cousins, I Bonds? (With I Bonds, it is their interest rate that is adjusted as a defense against inflation, whereas with TIPS their price or principal is adjusted.)
You can buy either through Treasury Direct.
There is no dollar limit to investing in TIPS. "There is a $10,000 per account per year limit to investing in I Bonds, which you can only buy directly from the U.S. Treasury," said Jayme Wiggins, a manager of $142.7 million Palm Valley Capital Fund (PVCMX). "TIPS are much more liquid and easier to transact."
Steven Saunders, director and portfolio advisor at Round Table Wealth Management, said, "TIPS ETFs allow for inflation adjustments to be paid out more frequently than if they owned the TIPS directly. This results in monthly income that can track changes in realized inflation more closely."
Follow Paul Katzeff on Twitter at @IBD_PKatzeff for tips about retirement planning and actively run portfolios that consistently outperform and rank among the best mutual funds.
