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Inflation to Pick Up in 2021: Bet on TIPS ETFs

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The market anticipates inflation to move higher next year as COVID-19 vaccines will lead to swift economic recovery. Notably, the 5-year TIPS/Treasury breakeven rate -- a proxy for inflation expectations measured by the yield difference in linkers and regular Treasuries – surged to the highest level since March 2019.

The potential vaccines by three firms so far — AstraZeneca (AZN - Free Report) , Moderna (MRNA - Free Report) and Pfizer (PFE - Free Report) — have shown strong effectiveness against the infection in the latest late-stage trial. The UK has already begun rolling out Pfizer vaccines this week, becoming the first country to start vaccinations for COVID-19, while the FDA is set to okay the emergency use of Pfizer/BioNTech's vaccine. Other firms like Sanofi (SNY - Free Report) , GlaxoSmithKline (GSK - Free Report) , Merck (MRK - Free Report) and Johnson & Johnson (JNJ - Free Report) are also in the process of developing the vaccine.

The vaccine optimism along with rise in some raw materials prices such as copper and lumber will lift inflation. The inflation rate could reach or surpass the Federal Reserve’s 2% target in some months. According to Mizuho International Plc’s Peter Chatwell “a resurgence in global growth in 2021, along with the Federal Reserve’s increased tolerance for inflation, should fuel price pressures and favor securities that protect against cost-of-living increases” (read: Fed Targets "Average Inflation" of 2%: ETF Strategies to Play).

The expectation for an uptick in inflation has led to investors’ flocking to Treasury Inflation Protected Securities (TIPS) ETFs. The ultra-popular iShares TIPS Bond ETF (TIP - Free Report) pulled in about $1.1 billion capital over the past six days, according to data compiled by Bloomberg. This marks the strongest inflow since early March, before the coronavirus upended financial markets and forced global lockdowns, crushing inflation expectations.

Why TIPS ETFs?

TIPS ETFs offer shelter against rising inflation. These not only combat increasing prices but also protect income for the long term. To explain in details, consider a fixed interest rate of 2.0% on five-year TIPS with initial face value of $1,000. In the first six months when inflation is zero, the semi-annual interest payment would be $10 but when inflation rises 5% annually in the next six months, the semi-annual interest rate would be $10.25 (1,025*2%-1/2 = 10.25).

This is because TIPS pay interest on an inflated-principal amount (principal rises with inflation) and in this case principal becomes $1,025 when the semi-annual inflation is accounted for. As a result, both principal amount and interest payments will keep rising with increasing consumer prices.

Given this, investors could bet on TIPS ETFs to combat inflationary pressure in 2021. While there are several options in the space to tap rising consumer prices, we have highlighted five funds that are popular and could be compelling investments (see: all the Inflation-Protected Bond ETFs here):

iShares TIPS Bond ETF (TIP - Free Report)

This ETF, having AUM of $25.3 billion and average daily volume of 2.4 million shares, tracks the Bloomberg Barclays U.S. Treasury Inflation Protected Securities (TIPS) Index (Series-L). Holding 47 securities in its basket, it has an effective duration of 7.61 years and average maturity of 8.13 years. The product charges 19 bps in fees per year (read: Weekly ETF Roundup: U.S. Equity Attracts, Gold Loses).

Schwab U.S. TIPS ETF (SCHP - Free Report)

This fund tracks the Bloomberg Barclays US Treasury Inflation-Linked Bond Index (Series-L), holding 45 securities in its basket. It has effective duration of 7.9 years and average maturity of 8.4 years. SCHP is among the cheapest option in the TIPS space, charging just 5 bps in annual fees. It has AUM to $13.5 billion and trades in solid volume of 981,000 shares a day.

Vanguard Short-Term Inflation-Protected Securities ETF (VTIP - Free Report)

With AUM of $9.8 billion, this ETF offers exposure to TIPS that have remaining maturity of less than five years by tracking the Bloomberg Barclays U.S. TIPS 0-5 Year Index. Holding 21 securities in its basket, it has average duration and average maturity of 2.7 years each. The product trades in average daily volume of 888,000 shares and charges 5 bps in annual fees.

iShares 0-5 Year TIPS Bond ETF (STIP - Free Report)

This fund offers exposure to short-term TIPS with effective duration of 2.53 years and average maturity of 2.55 years. It holds 18 securities in its basket and follows the Bloomberg Barclays U.S. TIPS 0-5 Years Index (Series-L). STIP has amassed $3 billion in its asset base and has 0.06% in expense ratio. It trades in average daily volume of 207,000 shares.

SPDR Portfolio TIPS ETF (SPIP - Free Report)

With AUM of $2.1 billion, this fund follows the Bloomberg Barclays U.S. Government Inflation-linked Bond Index and holds 43 securities in its basket. Average maturity comes in at 8.87 years while adjusted duration is 8.52 years. The fund charges 12 bps in annual fees and trades in good volume of 480,000 shares a day.

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