Combatting Inflation: TIPS Bonds and Hard Assets Provide Options to Keep Ahead of the Curve
Consumer price growth may well remain elevated over the medium term. To fortify portfolios, Laura Tase, Director, Institutional & Advisory, BMO ETFs, recommends Treasury Inflation-Protected Securities (TIPS), infrastructure and agriculture allocations.Apr. 19, 2023
The U.S. Federal Reserve and the Bank of Canada are starting to get inflation under control, with varying degrees of success. Although higher interest rates have begun to work, elevated consumer price growth may persist for some time with little indication at present that it will return to central banks’ target rate of 2% anytime soon. That’s created the near- and medium-term challenge for Investment Counsellors and Portfolio Managers (PMs) to contain inflation risk in their portfolios.
We suggest taking a look at TIPS in combination with non-cyclical hard assets, like global infrastructure and agriculture, which can strike a balance between capital protection and positive growth exposure. In volatile markets clients are naturally very conservative, yet it’s our view that being ultra-defensive can harm portfolios as much as protect them.
An optimal strategy is to add exposures that can a) protect against rising prices and b) provide growth in inflationary environments. Adding TIPS can achieve both investment objectives, with the Treasury bonds yielding a fixed real rate of return that is adjusted for inflation, while hard assets can generate income and offer the potential for price appreciation.
Let’s review what a TIPS bond is, and how it works before reviewing how BMO Global Asset Management has constructed its related funds around these securities.
What are TIPS?
TIPS are a type of U.S. government bond that provides protection against inflation by adjusting their par value based on changes in the Consumer Price Index (CPI). If the CPI rises, the principal amount of the TIPS bond increases. This adjustment is made on a semi-annual basis.
The interest payments on TIPS bonds are also adjusted for inflation. The interest rate is fixed when the bond is issued, but the amount of interest paid to investors is calculated based on the inflation-adjusted principal amount. So, if the inflation rate goes up, the amount of interest paid to the investor increases accordingly. See the example below.
The TIPS’ payout consists of two parts: the increase in CPI and the “real yield,” or the yield above inflation.
Pure play inflation hedge
The inflation-proofing characteristics of TIPS bonds were witnessed at the very outset of the current bout of elevated consumer prices dating back to January 2022. It was that monthly U.S. CPI print that convinced the market that this was not a “transitory” issue, and by the end of February 2022, TIPS outperformed non-inflation protected Treasuries.
Not surprisingly, that outperformance continued as the CPI climbed. The BMO Short-Term US TIPS Index ETF (ticker: ZTIP), which tracks the Bloomberg US Government Inflation-Linked 0-5 Year Bond Index, diverged from the BMO Short-Term US Treasury Bond Index ETF (ticker: ZTS) in February 2022 to deliver a total return of 3.84% for the year compared to 0.93%.1
BMO Short-Term US TIPS Index ETF (ticker: ZTIP) focuses on the short end of the curve to provide more of a “pure play” on inflation by avoiding longer duration risk. The index includes issuances with a minimum outstanding amount of USD$500 million. The Fund is also offered as hedged to Canadian dollars (CAD) (ZTIP.F) and in US dollars (USD) (ZTIP.U).
In January, the BMO US TIPS Index ETF (ticker: TIPS) was launched, similarly designed to protect investors against rising prices but with a focus on a full-term structure and longer duration to provide diversification across the yield curve. The fund too is offered hedged to CAD (TIPS.F) and in USD (TIPS.U).
In general, TIPS bonds are a low-risk asset for Counsellors and PMs who want to protect client purchasing power against inflation, and are a useful addition to a diversified portfolio when combined with other fixed income securities, such as traditional bonds that aren’t linked to CPI.
Infrastructure and agriculture
Managers seeking to further fortify their holdings against rising consumer prices while maintaining some defensive growth exposure may look to non-cyclical investments. Hard assets such as cellphone towers, pipelines, water systems, bridges and airports generally keep their value when inflation rises, while revenues are often indexed to inflation via long-term government contracts.
The BMO Global Infrastructure Index ETF (ticker: ZGI) replicates the Dow Jones Brookfield Global Infrastructure North American Listed Index, consisting of companies listed in North America with more than 70% of estimated cash flows derived from pure-play infrastructure assets. Those sectors and companies tend be less correlated to economic cycles, with operating margins that are maintained through ups and downs in the economy. To wit, infrastructure margins remained stable and elevated through the pandemic compared to more sensitive sectors such as energy, while relatively strong margins have produced consistently superior dividend yields compared to the S&P Global BMI and S&P North America BMI over the past decade.2
Global infrastructure: Historically strong and consistent operating margins, 2013-2022
In addition, a large component of recent inflation has been driven by increased food prices. A concentrated exposure to the largest global companies that produce or are involved with the production of food can serve as an effective hedge against inflation. The BMO Global Agriculture ETF (ticker: ZEAT) provides asset managers access to companies that are a) directly involved in the production process and b) can easily pass on costs to consumers.
It’s our view that ZEAT is well-positioned to deliver capital appreciation given its allocation to companies which are seeing increasing demand given ongoing food security risks driven by droughts in many regions, changes in farming practices, climate change, population growth and ongoing conflict in Ukraine.
For Investment Counsellors and PMs who hold expectations that elevated CPI prints could well remain a thorn in the market’s side for awhile yet, it’s imperative to look across asset classes for diversified solutions that solve for that while positioning clients for growth. We’d offer TIPS as well as hard assets in infrastructure and agriculture as viable means to achieve those objectives.
Please contact your BMO ETF Specialist for more information. Our Portfolio Managers are also available to help with trading insights. They can also be reached at 1−877−741−7263.
1 Bloomberg, BMO Global Asset Management, as of February 28, 2022. ZTIP annualized performance to March 31, 2023 – 1-year: 4.44%, Since Inception (January 20, 2021): 4.71%); ZTS annualized performance to March 31, 2023 – 1-year: 2.83%, 3-year: -1.27%, 5-year: 1.75%, Since Inception (February 28 , 2017): 0.73%.
2 S&P Dow Jones Indices LLC., data from April 30, 2013 to February 28, 2023.
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