How STRIPS And TIPS Made A Bad Year Worse

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Deagreez

Inflation & Inflation-Hedging Investments

Battling the steepest inflation seen in 40 years, the Federal Reserve has yet to curb inflation, despite being “strongly committed” to the cause. Equities are taking a hit despite many investors full steam ahead shorting the equity markets. As a former hedge-fund guy, betting on downturns can prove beneficial. But, there is a significant risk, and risk-averse investors who have chosen investments like Treasury Inflation-Protected Securities (TIP) and Separate Trading of Registered Interest and Principal of Securities “STRIPS” like (GOVZ) are finding that this “safer” option is not so safe and costing them money, too, to the tune of -14.12% YTD, and -33.65% YTD, respectively.

TIP vs GOVZ Price Performance

TIP vs GOVZ Price Performance (Seeking Alpha Premium)

While the markets may not have fully priced in higher inflation figures, “Rising real yields are among the clearest expressions of tighter financial conditions and a core headwind for speculative assets that are dependent on excess liquidity,” said Charlie McElligott, cross-asset strategist at Nomura Securities International. Company valuations and profits are taking a hit, especially in the technology sector, whose weights are substantial among the indexes. To date, the tech sector (XLK) is down 21.06%. And while the uncertainty moving the markets persists, ETFs offer many advantages over traditional open-end funds, including portfolio diversification, trading flexibility, reduced costs, and tax benefits, which we’ll discuss later in the article.

What are Treasury Inflation-Protected Securities (OTCPK:TIPS)?

Fluctuations in treasuries have investors on edge. TIPS -14% selloff is confusing investors, given that TIPS are bonds offered and backed by the U.S. Department of the Treasury to help protect against inflation. Hence, there’s nearly no credit or default risk. But as we’re seeing, TIPS can be volatile.

Not Exactly A Good Investment (TIP)

Poor Performing ETFs - TIPS

Poor Performing ETFs – TIPS (Seeking Alpha Premium)

With the economy in flux, TIPS maturities of five, 10, and 30 years should shelter investors from risk. Traditional bonds have two primary components: interest rate yield and price, which are inversely related. As interest rates rise, bond prices fall, and as interest rates fall, bond prices rise. Tips are just like any other bond. They are impacted by interest rate movements, so as the Fed has increased rates and market yields have spiked significantly over the year, the price of TIPS is negatively impacted. The principal value of the TIPS bond is tied and adjusted semiannually to the rate of inflation and based upon CPI changes. When inflation goes up, the principal value of the bond goes up, and investors receive an increased coupon payment and value at maturity if the adjusted principal is greater than the face value.

So why are people losing money if TIPS are supposed to be an inflation hedge, and inflation is at 8.5%? TIPS has a third component that a standard U.S. Treasury bond does not – an inflation adjustment to the principle. TIPS are declining this year because the price movement associated with rising interest rates is greater than the inflation adjustment to the principle, causing a negative return. Additionally, when CPI is adjusted downward, the principal value and subsequent coupon payments on TIPS are reduced accordingly, which could mean further headwinds if inflation has turned over and descends towards the Fed’s target.

2% Inflation Expectations

2% Inflation Expectations (Seeking Alpha Premium)

And while the market has implied that the breakeven rates for TIPS are nearing the Fed’s expected 2%, a fall in commodities like crude oil and fuel offers a vote of confidence that the Fed may be able to tame inflation. Whether this takes place remains to be seen, and what this means for STRIPS is another ball game.

What are STRIPS?

Unlike TIPS, Separate Trading of Registered Interest and Principal of Securities (STRIPS) are not backed by the government. Stripped bonds, aka STRIPS, are a form of a zero coupon bond developed by a “stripper” (typically an investment bank). STRIPS tend to be more volatile because you’re buying a set income stream or the coupon from treasury securities and bundling and selling them through a brokerage or financial institution (the strip dealers).

For This Sub-Asset Class, GOVZ Was One Of The Worst Performing Strips ETFs

Poor Performing ETFs - STRIPS

Poor Performing ETFs – STRIPS (Seeking Alpha Premium)

As you can see in the chart below, STRIPS are being negatively impacted and crushed in the current environment because they’re highly sensitive to interest rate movements and inflation, both of which have caused significant bloodshed in the bond markets over the last year. STRIPS may also be based on bundled Treasury interest rates from a year ago when yields were a fraction of what they are today. (GOVZ) is -33.65% YTD; think supply and demand.

iShares 25+ Year Treasury STRIPS Bond ETF (GOVZ) YTD Performance

GOVZ YTD Performance

GOVZ YTD Performance (Seeking Alpha Premium)

In today’s environment, there is little to no demand for lower levels of interest payments when you can buy a three-month treasury and get north of 3%. With inflation, the markets are experiencing oversold stocks and persisting market volatility. TIPS and STRIPS are not offering the returns investors would hope. Commodities have rallied and proven to be better investments over the last year. To concentrate on quality and high-demand asset classes and diversification, Seeking Alpha has launched an ETF screen, and many of the ETF strong buy recommendations serve as inflation hedges.

How To Identify Winning and Losing ETFs With ETF Grades

ETFs are not stocks. They trade similarly to stocks while acting like mutual funds because they are a basket of securities. The main difference is that ETFs trade in the open market, and you can buy and sell shares based on market price, which, unlike a mutual fund, may deviate from the net value of all the assets within the fund. ETFs are about supply and demand, so momentum plays a major role in ETF predictability. It is one of the featured ETF grades, along with Expenses, Dividend, Risk, and Asset Flows. The ETF grades determine each ETF’s direction rating (Buy/Sell). Notably, a proprietary aspect of Seeking Alpha’s ETF grades is that they symbolize the strength of each investment metric to the median of all ETFs. This provides an instant characterization of how any given ETF compares to our entire universe of ETFs. Premium subscribers will find a display card with ETF Grades on every Seeking Alpha ETF page.

Display Cards for SPDR S&P 500 Trust ETF (SPY)

Display Cards for SPDR S&P 500 Trust ETF (<a href='https://seekingalpha.com/symbol/SPY' title='SPDR S&P 500 Trust ETF'>SPY</a>)

Display Cards for SPDR S&P 500 Trust ETF (SPY) (Seeking Alpha Premium)

The card above highlights the ratings from SA Authors and the Quant Rating for the SPDR S&P 500 Trust ETF (SPY). It also displays the Quant ETF Grades and the Quant Ranking in the designated Asset Class, Sub-Asset Class, and overall rank compared to all ETFs. For the purposes of the Quant Rating, it is determined by rolling up the five ETF Grades: Momentum, Expenses, Dividend, Risk, and Asset Flows. The grades are not equally weighted as our backtest indicates that Momentum is the greatest predictive factor for ETFs.

Seeking Alpha Top Rated ETFs

ETFs can provide investors several advantages compared to single stocks, including portfolio diversification, tax benefits, risk management, and lower costs. Given the high demand for commodities – energy, fuel, and particularly natural gas – several ETFs in these asset classes and subclasses have offered investors upside, serving as inflation hedges and recession-resilient picks. Below is a snapshot of the most recent Top Rated ETF screener.

Top Rated ETFs

Top Rated ETFs (Seeking Alpha Premium)

As you can see, several top picks invest in companies that operate across energy, oil, and gas. Ranking in the top 10 of their asset class and sub-class, FCG and XOP are dominating. Both possess stellar momentum and asset flows, with a strong moat that demand will continue, given pricing competition and increased fuel costs worldwide. As fuel remains at the forefront of rising prices, there is still potential upside for these investments. Comparing the strong buy ETFs vs. TIPS & STRIPS, there’s a reason I emphasize avoiding bad ETFs.

Strong Buy ETFs vs. TIPS & STRIPS ETFs

Strong Buy ETFs vs. TIPS & STRIPS ETFs

Strong Buy ETFs vs. TIPS & STRIPS ETFs (Seeking Alpha Premium)

TIP and GOVZ are rated sell and strong sell, respectively, whereas FCG and XOP are rated strong buys. Strong demand for energy makes the longer-term bull case for ETFs like FCG and XOP in that these ETFs are likely undervalued as investors may not have priced in the full potential of energy. While some may argue that energy has peaked, as Leo Nelissen highlights, the weighted average price/earnings ratio for MSCI world energy stocks is at Great Financial Crisis lows.

IBES MSCI World Energy P/E Based on NTM

IBES MSCI World Energy P/E Based on NTM (Refinitiv Datastream)

In the last twelve months, FCG has been trading at 7.6x earnings, roughly equal to the chart above based on the next twelve months’ earnings.

“Investors find themselves confronted with a market unlike any they have experienced: inflation is high, growth is difficult to come by, and raw materials are in short supply after a decade of capital starvation. Even under the most strained deflationary and inflationary periods experienced in United States history, commodities and their related equities produced large positive nominal and real returns. Unfortunately, most investors remain woefully under-allocated to this important sector — ironic given commodity-related equities may be the only thing safeguarding capital in the years to come” – Goehring & Rozencwajg.

As we look at the demand for inflation protection as typically measured by Treasury debt which continues to decline compared to the ETF screens we’ve developed that highlight ETFs with great momentum and fundamentals, our tools help ensure your portfolio contains strong investments that increase over time. With the five-year expected inflation rate below 2.7% from its March 3.76% peak, why sell yourself short when there are so many good ETF options available? Consider using Seeking Alpha’s ETF screener to avoid bad ETFs while finding strong buy picks.

Conclusion

Where TIPS would typically help protect against inflation in the long-term, the short term has given way to price declines, as macroeconomic factors like inflation which has risen its fastest in decades, have proven costly for TIPS and STRIPS investors year-to-date. Given the uncharacteristic selloff this year causing TIPS to act more like bonds than inflation hedges, focus on avoiding bad ETFs like TIPS and STRIPS. Rather, consider quality ETFs.

While ETFs can be an investment vehicle that minimizes risk and maximizes diversification, they still require some research. As I previously wrote in an article,

“Not all ETFs are created equal, so it is important to analyze the construction and methodology when selecting an ETF, particularly index ETFs. For example, SPDR S&P 500 Trust ETF (SPY) is a market-cap-weighted index that seeks to mirror the performance of the S&P 500. So, underlying constituents are allocated by size relative to the other indexes, which is why when you look at the S&P 500, you’re not getting true exposure to all 500 companies. Instead, you’re getting a skewed allocation that comprises roughly the ten largest weighted stocks like Apple, Microsoft, Amazon, and Tesla, representing 27% of the index.”

ETFs have pros and cons depending on the market cycle, which is why we like to focus on quality screening criteria. Focusing on ETFs with solid liquidity and holdings, strong forward P/E, earnings, dividend growth, and free cash flow is a great way to locate high-quality ETFs and avoid losers. Seeking Alpha’s Top Rated ETFs offer the ability to filter by Quant & Author grades, as well as more than 50 other metrics. We will highlight some of our Top ETF picks below.

Seeking Alpha’s ETF quant screener has identified ETFs that are strong buys, and identifying those with quality characteristics and holdings can prove beneficial, offering strong long-term momentum, asset classes that are in demand, positive investor inflows, and rising AUM.

We have eight ETF asset classes to choose from that highlight ETFs with directional recommendations that range from Strong Buy to Strong Sell. The asset classes are:

ETFs are great for diversifying a portfolio. Many possess great outlooks and collective characteristics, with tailwinds for successful performance. Finding knowledgeable investment resources is a great way to be a successful investor in volatile markets. Consider using Seeking Alpha’s screening criteria link above to help you find an ETF that achieves diversification into desired sectors you like.

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