Most Popular ArticlesMay 19, 2009
Of course, TIPS holders could do the same and sell a portion of their holdings each month, but having this done automatically justifies the expense ratio of the ETFs. This can be costly in other ways, though, since the ETFs may be forced to liquidate a portion of their holdings at depressed prices if real interest rates are rising due to inflation.
The two ETFs recently suspended their distributions, because the downward adjustments to principal due to deflation at the end of 2008 overwhelmed their coupon income. TIP has reinstituted its distribution but IPE has not.
Scott Hein and Jeffrey Mercer of Texas Tech University studied the phantom tax, and found that ex-post after-tax yields on TIPS were about the same as the after-tax yields on nominal Treasury bonds, implying that the phantom tax is a non-issue. But it is a non-issue only if the investor has the cash to pay the tax. Otherwise, it’s a real issue, especially if the investor must sell TIPS to pay the phantom tax.
Like any ETF, TIP and IPE can trade at a discount or premium to their NAV. In the fourth quarter of 2008, these discounts and premia were between 3% and 4%, but are much narrower now.
Who should own TIPS
TIPS remain the only pure hedge against inflation for a US-dollar based investor. Individual investors who have saved enough to fund their retirement at their desired standard of living based on the real interest rates offered by TIPS should be invested 100% in them. Any excess funds can be invested in riskier securities. But very few investors are this fortunate, and will own other riskier asset classes with inflation-hedging properties.
Investors funding retirement accounts should own TIPS with maturities that match those of their liabilities or, more precisely, with durations that match those of their liabilities. Therefore, individual TIPS are preferable to ETFs, which have a constant maturity and duration.
Ideally, TIPS should be held in a pension fund or other tax-sheltered account, eliminating the phantom tax issue and facilitating the ownership of individual bonds.
TIPS are volatile, and are best suited for investors that can hold them to maturity.
The two charts presented in this article are from Wachovia Securities. Their disclaimer follows:
Wachovia Securities (Wachovia Securities, LLC and Wachovia Securities Financial Network, LLC) is now Wells Fargo Advisors.
Although Treasuries are considered free from credit risk they are subject to other types of risks. These risks include interest rate risk, which may cause the underlying value of the bond to fluctuate, and deflation risk, which may cause the principal to decline and the securities to underperform traditional treasury securities.
Bond prices fluctuate inversely to changes in interest-rates. Therefore, a general rise in interest rates can result in the decline of the value of your investment.
Yields and market value will fluctuate, so that your investment, if sold prior to maturity, may be worth more of less than its original cost.
The Advisor Services Group (“ASG”) of Wachovia Securities, LLC (“WSLLC”), works with information received from various resources including, but not limited to, research from affiliated or unaffiliated research correspondents as well as other sources. The ASG strategists strive to provide unbiased investment advice for the clients of WSLLC and its affiliates. The Advisory Services Group does not assign ratings to or project target prices for any of the securities mentioned in this report.
As part of our unbiased investment advice, we often cite individual securities. Research on these securities is obtained by our Strategists from at least one of the correspondent research providers with which WSLLC has an agreement to obtain research reports. Each correspondent research report reflects the different assumptions, opinions, and the methods of the analysts who prepared them. For copies of research reports that may have been used in this publication, please contact your financial advisor.
Disclaimers
We recognize that each client’s investment needs and goals are different. Therefore, this report should not be construed as an offer to sell, or as a solicitation of an offer to buy, the securities or instruments mentioned. Any opinions or estimates contained in this report constitute the judgment of the Strategist as of this date and are subject to change without notice. Wachovia Securities, LLC, or its affiliates may provide advice or may from time to time acquire, hold or sell a position in the securities mentioned herein.
Wells Fargo Advisors is the trade name under which Wells Fargo Corporation provides brokerage services through two registered broker-dealers: Wells Fargo Advisors, LLC, member NYSE/SIPC, and Wells Fargo Advisors Financial Network, LLC, member FINRA/SIPC. Each broker-dealer is a separate non-bank affiliate of Wells Fargo Corporation.
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