LTPZ: Rising Yield, Increasing Risk (NYSEARCA:LTPZ)

~ by Snehasish Chaudhuri, MBA (Finance)

PIMCO 15+ Year U.S. TIPS Index Exchange-Traded Fund (NYSEARCA:LTPZ) invests in U.S. dollar denominated Treasury Inflation-Protected Securities (TIPS) with a maturity of at least 15 years. Its primary objective is to provide inflation protection to the invested capital.

Historically, LTPZ had recorded an average yield between 1 to 3 percent, but that increased to 5.83 percent in 2022, primarily due to higher interest income as well as huge fall in its market price. During this period the price dropped by more than 30 percent. As the fund’s holdings are indexed to inflation, this exchange-traded fund (“ETF”) stands to gain in terms of strong yield, and overall return, in case the inflation remains elevated. But, in the absence of any inflation, LTPZ may bring more pain than the gains made by it.

PIMCO 15+ Year U.S. TIPS Index Exchange-Traded Fund

LTPZ was launched on September 3, 2009, and is managed by Pacific Investment Management Company LLC. The fund, with assets under management (AUM) of $620 million, aims to achieve inflation adjusted return, capital preservation, and stability w.r.t changes in real interest rates. Long maturity TIPS by default possess the ability to absorb the impacts of changing interest rates. It seeks to benchmark itself against the ICE BofA 15+ Year US Inflation-Linked Treasury Index, which is an unmanaged index of TIPS with a maturity of at least 15 years. LTPZ employs representative sampling techniques in order to replicate the underlying index.

As investors can’t invest directly in an unmanaged index, LTPZ becomes a strong option for investing in the 15 plus years TIPS Index. PIMCO has been actively managing TIPS since the very inception of the TIPS market in 1997 and currently is one of the biggest players. Leveraging on its exposure in the TIPS market, PIMCO has launched this fund in order to allow investors to protect their investments from inflation risks. This fund seeks to avail investors of the potential benefits of long maturity TIPS exposure at a very low cost. LTPZ has an effective maturity of 22.65 years, and has an extremely low expense ratio of 0.2 percent.

How Do Treasury inflation-protected securities (TIPS) Work?

TIPS are inflation-indexed securities issued by the U.S. government, having maturities of 5, 10, and 30 years. As they are issued by the federal government, they are considered low-risk investments. TIPS can either be purchased through the Treasury-direct system or through a mutual fund or ETF. However, investors can avoid the management fees associated with mutual funds or ETFs if they purchase TIPS directly from the government through the Treasury-direct system. While other fixed income securities increase their yield in response to increase in inflation, TIPS adjusts its principal amount in order to protect its real value. That means, the principal amount of TIPS increases with inflation.

Thus, TIPS protect its investors from inflation. It also profits from inflation, as TIPS pay interest every six months based on a fixed rate that is pre-determined at the time of the auction. However, the interest amounts may vary since the predetermined interest rate is applied to the adjusted principal. Due to this, investors earn higher interest income as inflation rises. Conversely, investors’ interest income goes down during deflation. At maturity, investors receive the higher of adjusted principal or the original principal. However, if an investor sells TIPS before the date of maturity in the secondary market, then he might receive less than the original principal.

In absence of any kind of inflation as measured by the Consumer Price Index (CPI), $1,000 investment in TIPS, with a coupon rate of 1%, will mean an interest payment of $10 over a year. Now, if inflation rises by 2%, the $1,000 principal will become $1,020. As the coupon rate will remain the same at 1%, interest on the adjusted principal amount will now be $10.20 for a year, and the investor will get $1020 back on maturity. Conversely, in case of deflation, if the price falls by 5 percent, the principal value will be reduced to $950, and interest payment will be reduced to $9.50. However, the maturity value will still be $1,000 due to the higher of adjusted principal and original principal.

Investment Thesis

As the U.S. economy has witnessed a 40-year high inflation, the principal value of LTPZ’s holdings also have increased and may increase further. The fund is going to benefit from the higher adjusted principal both due to high interest, as well as higher maturity value. LTPZ’s interest payment is set to increase as the interest amount will be calculated upon the adjusted principal balance. This has already significantly enhanced LTPZ’s yield. As mentioned earlier, investors will get the higher of original principal or inflation-adjusted principal. Thus, the fund should attract more investments. As the price of LTPZ has dropped down by more than 30 percent in 2022, it may seem that it’s an appropriate time to buy this fund.

However, all TIPS, including LTPZ, usually pay lower interest rates than other government or corporate securities, so they are not necessarily optimal for income-seeking investors. Moreover, the effective yield of LTPZ is negative, if we consider the impacts of current levels of inflation. As I said, LTPZ is mainly meant for inflation protection, but once this inflation comes down or becomes nonexistent, its utility will decrease. If no further inflation takes place once the current economic scenario stabilizes, which cannot be predicted over longer periods of time, the utility of holding this TIPS decreases dramatically.

In addition, the interest and inflation adjustments on TIPS, though, are exempted from state and local taxes, the Internal Revenue Service (IRS) calculates taxes on the inflation adjustment. This means, investors of these TIPS have to pay taxes, despite not receiving it at this point of time, as the benefits of inflation adjustments can only be liquidated on maturity. Investors may also be subject to higher taxes on increased coupon payments.

If we consider all these factors, then LTPZ becomes quite a risky investment avenue. Under such circumstances, It will not be a wise decision to invest in a fund for a very long term for a reasonably good yield for a year or two.