Ibrahim Akcengiz
Schwab U.S. TIPS ETF (NYSEARCA:SCHP) is an exchange-traded fund (“ETF”) that invests in Treasury Inflation Protected Securities (“TIPS”). All these securities are AAA rated, and have a weighted maturity of 7.38 years. The fund generates strong current yields and works as an inflation hedge. As inflation increases, the return from this fund increases, too. Thus, this fund has delivered good returns during the current inflationary environment. However, these benefits may soon convert into a disadvantage, once inflation normalizes.
A low level of inflation would be a disadvantage for investors of Schwab U.S. TIPS ETF. The Federal Reserve has set its target for a 2 percent annual inflation. Before the covid-19 pandemic, SCHP’s yield mostly ranged between 1.4 percent and 2.4 percent from 2012 to 2019, somewhere in the range of the Fed’s long-term inflation target. Once the inflation rate normalizes, SCHP will have to decrease its payout significantly, perhaps by half the current amount. Although the rate of inflation likely is not going to slow in the coming months, it will surely normalize in the coming years.
SCPH generates strong current yields, works as a hedge against inflation
Schwab U.S. TIPS ETF was launched in August 2010, and is managed by Charles Schwab Investment Management, Inc. The fund primarily invests in dollar denominated fixed-rate non-convertible, investment grade treasury inflation-protected securities that have at least one year remaining to maturity. TIPS are a type of treasury security that are indexed to inflation in order to protect investors from a decline in the purchasing power of their money. When inflation goes up, TIPS adjust its price (principal amount) instead of adjusting its yield. In that way, TIPS maintain their real value despite changing their yield.
Schwab U.S. TIPS ETF seeks to track the performance of the Bloomberg Barclays US Treasury Inflation-Linked Bond Index (Series-L), by using full replication techniques. The index includes all publicly-issued investment grade TIPS having maturity of one year or more, and that have an outstanding face value in excess of $500 million. SCHP generated an average yield of 5.88 percent during 2022, and is expected to see such high yield till the time inflation remains high. This ETF has paid monthly dividends since the very beginning, i.e., for more than 12 years.
How TIPS are helpful in the current macroeconomic situation
Treasury Inflation Protected Securities are the safest assets as these are backed by the US government having maturities of 5, 10, and 30 years. However, they have very low coupons. TIPS have the additional benefit of being a hedge against inflation. The inflation may also benefit TIPS as interest is calculated with a predetermined fixed rate, but the principal amount may go up. The interest amount may increase in such cases, and investors will thus earn higher interest income as inflation rises.
In the case of the Consumer Price Index (“CPI”) remaining constant, $1,000 investment in TIPS, with a coupon rate of 2 percent, would mean an interest payment of $20 over a year. Now, if inflation rises by 1 percent, the $1,000 principal will become $1,010. As the coupon rate will remain the same at 2 percent, interest on the adjusted principal amount will now be $20.20 for a year, and investors will get $1010 back on maturity. At maturity, investors receive the higher of adjusted principal or the original principal, i.e. 1010 in this case.
Conversely, investors’ interest income goes down during deflation. If the inflation falls by 1 percent, the principal value would be reduced to $990, and interest payment will be reduced to $19.80. Investors would still receive the original principal of $1000 on maturity, as this will be more than the adjusted principal of $990. However, investors have to hold these TIPS till the maturity, and they will forgo this benefit in case they sell these TIPS in the secondary market. Thus, TIPS are protected from adverse impacts of inflation, as their face value and interest rate payments are indexed to the CPI.
The returns are roughly equal to their interest rate plus inflation. Deflation, on the other hand, has adverse effects. TIPS Bonds doesn’t make anyone rich, but they protect the investments from both major downsides in the stock market, amid rising inflation concerns. In these uncertain macroeconomic conditions, TIPS ETFs have already proven useful as they have delivered a year-to-date (“YTD”) growth within a range of 0.75 percent and 2 percent. Inflation is at a multi-decade high, and currently ranging around 8 percent.
The current macroeconomic situation indicates that this trend will continue in the coming months. Oil prices have peaked and logistics and supply chains have deteriorated as a consequence of the Russian-Ukraine conflict. Higher energy prices are the root cause of inflation as it increases input costs for most manufactured goods. On the other hand, supply chain issues increase costs for the majority of consumable products. As a result of both, the overall price will keep on increasing. As the inflation rate is expected to remain high in the coming months, Schwab U.S. TIPS ETF is also expected to offer higher dividend payments. Ultimately, SCHP’s shareholders will get a higher return.
Investment Thesis
SCHP’s current yield is significantly higher than the average and is quite attractive relative to treasuries, bonds, savings accounts, and other similar investments. Strong yields are almost always a benefit for a fund and its shareholders, and the Schwab U.S. TIPS ETF is no exception. However, that might not be the case after the Federal Reserve hikes rates to combat rising inflation. Very recently, in 2018-19 investors, experienced economic weakness and a financial market meltdown due to rate hikes. The Fed had to go for a policy reversal and reduced the interest rates.
In another instance, aggressive rate hikes during 1994, lowered inflation and slowed the economic growth, which nullified a three-year period of strong growth and equity markets. As the Federal Reserve is tightening its credit policy in response to inflation, investors are worried about its probable impacts this time too. Schwab U.S. TIPS ETF has outperformed its own average performance prior to covid-19 pandemic, mainly due to rapidly increasing inflation. There is a category of investors who are currently investing in SCHP to hedge their portfolios against inflation. However, in case the inflation rate comes down, it will reduce demand for TIPS, leading to lower prices and higher capital losses.
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