Buying iShares Barclays TIPS Bond (TIP) ETF versus Individual TIPS

In this Ask the Expert with Larry Swedroe article, Thomas is wondering why his iShares Barclays TIPS Bond TIP ETF hasn’t paid dividend since last October and if he should switch to individual TIPS through Treasury Direct instead. Here’s the question from Thomas:

I own the TIP ETF (iShares Barclays TIPS Bond). It has not paid a monthly dividend since last October. Should I buy more TIP or invest in a new issue through Treasury Direct in July?

Answer From Larry Swedroe

TIPS as the preferred choice for tax advantaged fixed income investing

As explained in the chapter in my new book, The Only Guide to Alternative Investments You’ll Ever Need, the academic research clearly comes down on the side of TIPS as the preferred choice for tax advantaged fixed income investing. The reason are that:

1. While short term nominal Treasury securities have no correlation to equities, and long term Treasury bonds have low correlation to equities, TIPS have negative correlation to equities, and, therefore are a better diversifier of the risks of equities.
2. Longer term TIPS have the advantage of eliminating the inflation risk inherent in longer term nominal bonds while still allowing you to capture the term premium.

Dividend for TIPS is irrelevant

As to the dividend, or lack thereof, you should ignore that issue. It is irrelevant. All you should care about is that you are getting the real return. With an ETF you basically own an index of TIPS with an average maturity of 9-10 years. So you are earning the real rate for that group of securities. The lack of the dividend was due to the deflation we experienced for the period you referred to. And if you check the value of your fund you will see it has actually risen nicely so far this year — roughly 5%.

Real return versus nominal return

The problem that investors have is that they are fooled by the money illusion — confusing real with nominal returns. Example, would you rather earn 5% when inflation is 5% or 2% when inflation is -1%? Clearly better off with the latter situation.

And that is even before taking taxes into account. You get taxed on the “phantom” (non real, or nominal) income. So assume you are in the 40% bracket, the 5% nominal return in the first case would yield you just 3% after taxes and with inflation of 5% your real return was -2%. In the latter case you earned a 2% return plus you had deflation of 1% providing a real return of 3%.

TIPS are good hedge against both inflation and deflation

TIPS actually are the only instrument that hedge both inflation and deflation. In fact they perform best if cumulative deflation occurs because they mature at par. If you buy a TIPS at par and you have cumulative inflation over the life you earn the stated real return. However, if the inflation factor is negative at maturity your return would be higher than the stated coupon on the TIPS you bought because while the inflation factor might be say 90 at maturity you get paid back par (easier to understand with an individual TIPS, but the principal works for a fund as well).

Individual TIPS are more cost efficient

One last point. If you don’t mind the extra work I prefer to own individual TIPS (only benefit of a fund is the convenience as don’t need to diversify risk because there is no credit risk). Not only do you save the expense ratio and trading costs but you control the maturity. My book goes into detail about why I call a shifting maturity strategy.

Bottom line stick with the TIPS (and read the chapter so you understand them better).

I hope the above is helpful.

Best wishes,

Larry

Disclaimer: Mr. Swedroe’s opinions and comments expressed are his own, and may not accurately reflect those of the firm, nor Moolanomy and its owner.

Larry Swedroe

Larry Swedroe is a principal and director of research at Buckingham Asset Management, LLC, an SEC Registered Investment Advisor firm in St. Louis, Missouri. He is also principal of BAM Advisor Services, LLC, a service provider to investment advisors across the country, most of whom are affiliated with CPA firms. However, his opinions and comments expressed within this column are his own, and may not accurately reflect those of Buckingham Asset Management or BAM Advisor Services.

Before joining Buckingham in 1996, Larry served as senior vice president and regional treasurer at Citicorp and vice chairman of Prudential Home Mortgage. Larry is author of The Only Guide to a Winning Investment Strategy You’ll Ever Need (updated and re-released in 2005), as well as six other books. Most recently, he authored The Only Guide to Alternative Investments You’ll Ever Need (2008).

Larry has started his own blog called Wise Investing at CBS Money Watch. Please check it out!