A TIP for Fixed Income Hedging

by Jay Pestrichelli on May 1st, 2012

As bonds have come to be a topic of regular discussion, we thought it made sense to point out one fixed income class that is actually trending upward and even recently hitting new highs. We’re talking about TIPS Bonds.

TIPS are fixed income vehicles that are linked to inflation through the change in the Consumer Price Index (CPI). Essentially as inflation goes up, the payout on the bond goes up. At Buy and Hedge we like to watch the ETF that best reflects this fixed income vehicle, which is symbol TIP.
So far, TIP has been on an uptrend this year. But what does that tell us? Is it all inflation expectation? Most likely it is, but there is also a component of the underlying government bond that is influenced by the risk-free cost of capital. This refers to the rate that banks would pay on idle cash and is predominantly influenced by the Fed Funds rate.

So while most investors, including us, are warning that its time to be careful of rising interest rates for fixed income holdings, TIP can act as an effective hedge against both inflation and rising rates.

TIP has an active options market, which makes hedging very manageable. For about a 1% annual cost, puts can be bought to provide downside protection at a 5% decline.

Add to the mix that TIP has a decent dividend, around 3%, and hedging gets even cheaper. But be careful because it is still a bond fund. Which means that if the underlying drops there is no par value payout, but that’s why we hedge.

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