Exploiting Inflation to Advantage: Trade Play

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How to Play Expected Inflation From the TIPS Spread

By: Kirk Lindstrom

The “TIPS Spread” is a simple comparison between the yield of Treasury Inflation Protection Securities (TIPS) and the yield of conventional U.S. Treasuries with the same maturity date. You calculate the TIPS Spread by subtracting the current yield on TIPS from the nominal U.S. Treasury bond yield for the term in consideration.

The “TIPS Spread” tells you what Treasury bond investors, on average under normal conditions, expect for the average inflation over the term. Those who expect inflation to be higher than the spread will buy TIPS. Likewise, those who expect inflation to be lower than the spread buy regular U.S. Treasuries.

For example, today the 10-year TIPS has a base rate of 1.32%. When you subtract that from the 10-year Treasury yielding 3.63% you get a difference of 2.31%. This means Treasury investors "break-even" in TIPS vs. regular U.S. Treasuries if inflation averages 2.31% over the next 10 years. TIPS will do better if inflation is higher.

Likewise, the longest maturity available is the 30-year TIPS which has a 2.16% base rate. When you subtract that from the 30-year Treasury yielding 4.69% you get a difference of 2.53%. This means Treasury investors "break-even" if inflation averages 2.53% over the next 30 years.

This chart shows the historical base rates for TIPS with maturities of 5, 10, 20 and 30 years back to 2004 plus the "expected inflation" rate using the 10 and 30 year TIPS spread.

Exchange traded funds that invest in TIPS include:

• iShares Barclays TIPS (TIP)
• PIMCO 1-5 Year U.S. TIPS (TIPZ)
• Schwab U.S. TIPS (SCHP)
• Managed mutual funds that invest in TIPS include:
• Fidelity Inflation-Protected Bond (FINPX)
• Vanguard Inflation-Protected Secs Inv (VIPSX

DISCLOSURE:

The author owns a very small amount of gold hidden in the house for bribes if we see Armageddon but I own "treasury inflation protected securities" (TIPS) mutual funds (like the ETF TIP or managed funds FINPX, VIPSX) and Series I-Bonds as well as individual TIPS. He also believe it is a good time to own equities including SPY, the exchange traded fund for the S&P500, for both inflation protection and income. Unless something major changes with the markets, he plans to buy the 30-year TIPS with the 2/15/2041 maturity date on the auction that closes on 2/17/2011 directly through a broker for regular and ROTH IRAs.