SCHP - SCHP: A Time For Nominal

2023-09-18 07:51:34 ET

Summary

• Schwab U.S. TIPS ETF is designed to provide investors with a hedge against rising inflation by investing in Treasury Inflation-Protected Securities.
• SCHP offers exposure to a wide range of TIPS issued by the U.S. government, providing a reliable and low-risk avenue for participating in inflation-protected fixed-income markets.
• While SCHP has performed well in terms of inflation protection, it may be outperformed by nominal Treasuries in a slowing inflation and declining interest rate environment.

There are only three ways to meet the unpaid bills of a nation. The first is taxation. The second is repudiation. The third is inflation. - Herbert Hoover

The last two years have been interesting for investors in Treasury Inflation Protected Securities. Most probably thought that TIPS would do well given CPI, but depending on duration, performance was likely disappointing for most. And while now it's tempting again to buy into TIPS because of a potential resurgence in cost-push inflation through Oil, I'd argue nominal Treasuries are set to outperform. Regardless, it's worth exploring what buying into a TIPS ETF looks like.

The Schwab U.S. TIPS ETF ( SCHP ) is an exchange-traded fund designed to track the performance of the Bloomberg US Treasury Inflation-Linked Bond Index. The primary aim of the fund is to provide investors with a reliable hedge against rising inflation. By investing primarily in Treasury Inflation-Protected Securities, the fund seeks to preserve the purchasing power of investors' capital in inflationary environments. This investment strategy could be particularly valuable during times when inflation threatens to erode the real value of traditional fixed-income investments.

Key Features of SCHP

SCHP stands out for its straightforward, low-cost structure, making it a potentially tax-efficient investment option. The fund is designed to serve as a core component of a diversified portfolio. It offers exposure to a wide range of TIPS issued by the U.S. government. These securities, backed by the full faith and credit of the U.S. Treasury, provide investors with a reliable and low-risk avenue for participating in inflation-protected fixed-income markets.

When we look at the total return ratio of SCHP to the iShares 7-10 Year Treasury Bond ETF ( IEF ), it's clear that since the Covid low, inflation protection won out substantially. Note however that SCHP seems to be in a large sideways distribution pattern against nominal Treasuries, suggesting that the inflation protection edge of TIPS broadly has gotten dull.

Analysis of SCHP Holdings

SCHP provides exposure to a broad range of TIPS across various maturities, thereby spreading their inflation protection across a range of durations. Its holdings are solely U.S. government securities, making it a secure investment option. As of last week, the fund held 50 securities, with total net asset of over $11 billion.

Assessing the performance of SCHP requires an understanding of its yield and returns. As of September 14, 2023, the fund had a 30-day SEC yield of 5.72%, a distribution yield of 4.23%, and an average yield to maturity of 4.24%. These yields suggest that SCHP offers a reliable income stream, adjusted for inflation, to its investors.

However, it's essential to remember that these yields are subject to change based on fluctuations in the inflation rate. For instance, the fund's high yield in 2022 was primarily attributable to the rise in the inflation rate, and such high yields might not be repeated in the future.

It's also worth noting that the duration is 6.7 years. This makes it sensitive to interest rate changes independent of CPI, though not as much as other longer duration and more volatile TIPS funds.

SCHP in the Context of Inflation and Interest Rates

I alluded to the idea that one needs to consider more than just inflation when looking at TIPS. An interesting aspect of SCHP and similar TIPS-focused ETFs is their relationship with inflation and interest rates. In 2022, despite soaring inflation rates, SCHP delivered a negative total return. This was largely due to the impact of duration risk on TIPS-focused ETFs.

However, in a scenario where inflation is slowing down, and market expectations for interest rates are declining, SCHP could potentially deliver better performance. This is because a decline in interest rates can provide a duration tailwind that can counteract the impact of slower inflation on the CPI adjustments of TIPS bonds.

Final Thoughts

The Schwab U.S. TIPS ETF is an investment vehicle that offers protection against inflation while providing a steady income stream. It is well-positioned to perform best in a slowing inflation and declining interest rate environment, which I suspect is an environment that will continue. However, should we be entering a risk-off period where inflation expectations precipitously fall, nominal Treasuries without the inflation protection would likely outperform for a trade. Overall, while I like Treasuries here and SCHP, I think there's better potential for nominal Treasuries to outperform as disinflation concerns get more aggressively priced into the bond market.

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