VTIP - VTIP: TIPS Offer Attractive Real Return Yields Now

Summary

• Real yields on 10-Year TIPS have recently surged to 1.5%, the highest level since 2010.
• The 10-Year breakeven inflation rate is still hovering between 2.25-2.50%.
• Wall Street does not appear concerned right now about inflation over the long term.
• Numerous economic data reports released last week revealed inflation is still quite elevated. I think investors need to hedge themselves.
• In my opinion, Vanguard Short-Term Inflation-Protected Securities ETF offers a great, low-cost solution for investors looking to hedge their portfolios.

Summary

While it's been an interesting start to 2023, I found last week in particular quite compelling. There were numerous U.S. economic data reports released, and all told the same story in my opinion: inflation isn't tamed, yet . Here's a high-level summary of the reports released last week:

1. Consumer Price Index ((CPI)): Higher than expected in January at +0.5% month-over-month, or +6.4% over the last twelve months.
2. Producer Price Index ((PPI)): Higher than expected in January at +0.7% month-over-month.
3. Retail Sales: Higher than expected at +3% in January, topping estimates of +1.9%. While this isn't necessarily tied to inflation, it shows consumers are still spending despite rising interest rates and inflation.
4. Personal Consumption Expenditure ((PCE)): Known as the Fed's favorite inflation gauge, it was up +5.2% in January, higher than estimates.

Investors shouldn't overanalyze this data. It's clear in my opinion that inflation is still prevalent in the U.S. economy, and the average already American knows that. Prices are still elevated across many sectors, and we simply don't know how long this is going to last. If history is any indicator, these inflationary cycles can last longer than Wall Street currently expects.

We are almost two months into 2023, and there is a lot of evidence (as mentioned above) supporting the Federal Reserve will need to continue raising rates for longer. Economic data is topping estimates, but what I find interesting is that Treasury Inflation-Protected Securities, or TIPS for short, have barely reacted. In fact, over the last few months, the real rate of return on TIPS has surged to levels not seen since 2010. This is the opposite of what a rational investor would expect after last week, but it's mainly due to treasury bonds still offering high yields. Break-evens are still hovering in the 2.25-2.50% area, Wall Street does not appear concerned about inflation in the long term.

However, when considering all of the economic data recently released along with the reaction to current yields on TIPS, I think there is a decent opportunity now to hedge your portfolio against further increases in inflation. This isn't a pure-play recommendation, but rather an opportunity to hedge if you haven't already. The proof is in the pudding after last week. We are not out of the woods yet. We don't have concrete proof that inflation will return back to its target of 2-3% target, yet. Historically, over the last ten years, key inflation metrics are still very elevated.

There are quite a few options to hedge against inflation in today's market. Whether you want an exchange-traded fund ("ETF"), Mutual Fund, or to buy TIPS directly from Treasury Direct , the options seem endless. I personally think the easiest way to gain exposure is simply using a passive ETF, and Vanguard offers a great product to do so.

Why I Like VTIP

The Vanguard Short-Term Inflation-Protected Securities ETF ( VTIP ) is an excellent vehicle for investors looking to hedge against inflation.

1. Low-Cost: With an expense ratio of only 0.04%, it's hard to beat.
2. Trusted Name Brand: Vanguard has been around for almost fifty years now and has built a reputation that doesn't need explaining. The company offers plenty of transparency on its fund overview page for VTIP to reassure investors of what they are holding. You can see every bond the fund holds, its performance against the benchmark, dividend history, etc.
3. Liquidity: Vanguard Short-Term Inflation-Protected Securities ETF is one of the largest inflation-protected bond ETFs out there currently, with over $15 billion in assets under management ("AUM"). This is helpful in maintaining a tight bid-ask spread if you need to buy or sell quickly at the best price.

Conclusion

Let me be clear - no one knows where inflation will be in ten years. There are too many variables to consider, such as technological advancements or population size changes in the coming years.

However, I do believe Wall Street is downplaying the current inflation trends. If you firmly believe that inflation will be higher than 2.5% annually over the next ten years, or at least expectations around that will change, then gaining exposure to TIPS is a great move now. There are rumors circulating now about what the new terminal policy rate will be over the long term from the Federal Reserve, some even suggesting it's over 5%. Again, if the 1970s was any indicator of what this decade ahead will look like, we are in for quite a surprise. History might just repeat itself.

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