The fourth-quarter move in 10-year U.S. Treasury yields (to 93 basis points from 68 basis points) helped write a surprising coda for financial markets in a year marred by the human and economic fallout of the pandemic.
With more fiscal stimulus on its way, consumer savings high and talk of pent-up demand unleashed by a vaccinated populace, long-dead inflation appeared to be ready for a comeback.
Though Federal Reserve Chairman Jerome Powell attempted to quash that narrative in a recent discussion with the Princeton University Bendheim Center for Finance on Jan. 14, participants in the exchanged-traded fund market had already bought the narrative that the outlook for intermediate-term inflation had shifted higher.
According to analysis from CFRA Research, ETFs targeting Treasury inflation-protected securities gained $12.8 billion in net flows to close the year at $60.9 billion in assets under management. Such a heady rate of asset growth in ETFs (21%) was only slightly below other areas of the bond market that saw explicit Fed support or legislation to boost credit (corporates, municipals, mortgages). And these investors were rewarded as ETFs tracking intermediate to longer-term TIPS returned 10% to 22% in 2020, according to CFRA.
With such performance from the asset class last year, Leslie Falconio, senior fixed income strategist Americas for UBS Financial Services Inc., reined in her preferred allocation to TIPS to neutral in a Jan. 8 research note.
At the end of 2020, TIPS comprised 7.5% of $21 trillion U.S. Treasury securities outstanding, according to the Securities Industry and Financial Markets Association. In December, TIPS traded, on average, $14.7 billion per day, compared to $175 billion per day for Treasury bills.
The relatively small nature of this market — and the long-dead specter of inflation generally — has attracted very little TIPS or inflation-related offerings by ETF issuers, but there's nothing like a hot market to awaken the creative juices among ETF providers.
"Following the growth of fixed-income ETFs in 2020, I would expect more attention and more products to this underserved market," said Todd Rosenbluth, director of mutual fund and ETF research at CFRA Research. "There's a lot of room for innovation and, apparently, plenty of time for issuers to be rewarded."
Most current products target a broad index of TIPS exposure or some portion thereof. For example, the iShares TIPS Bond ETF from BlackRock holds $26.4 billion in assets across the TIPS curve, whereas Pacific Investment Management Co. LLC and Northern Trust Asset Management offer products with longer or shorter maturities or targeted duration.
In a September research note, the BlackRock Investment Institute identified three factors that could contribute to a "higher inflation regime." First, the added costs of labor and production due to COVID-19, on top of "deglobalization and the remapping of supply chains," will put pressure on companies to raise prices. Second, the Fed's new policy framework is "designed to push inflation above its 2% target to make up for past shortfalls." And third, the "blurring of fiscal and monetary policy" has made monetary policy more politicized and "could call in question the credibility of inflation targets and confidence in central banks."
At the time, BlackRock saw "a window of opportunity for long-term investors" in inflation-linked bonds and alternatives. Given the return experienced by TIPS to close out the year, that window may be closing.
Experimentation in products investing in TIPS or attempting to isolate shifts in inflation expectations had little success until the 2019 launch of the actively managed Quadratic Interest Rate Volatility and Inflation Hedge ETF. The product, with $1.1 billion in assets under management, primarily holds a TIPS index ETF managed by Charles Schwab Investment Management and options on the U.S. interest rate swap curve.
"Going long interest rate volatility is a better solution for inflation hedging," said Nancy Davis, managing partner and chief investment officer of Quadratic Capital Management.
Mr. Rosenbluth expects to see issuers bring more exotic active fixed-income strategies to market, following the path of advisers that have translated separately managed accounts or hedged portfolios to ETFs.
While holding equities will always be the ultimate inflation hedge, the ETF market also offers products with exposure to precious metals, energy commodities and agricultural futures.
"The focal point for inflationary pressures may be the agriculture complex, where corn, wheat and soybean prices are at the highest levels since 2014," said Dave Lutz, Annapolis, Md.-based head of ETF trading for Jones Trading LLC.
And not only are there individual ETFs tracking those commodities, the $38 million iShares MSCI Global Agriculture Producers Index ETF was already up 7% this year through Jan. 15, after gaining 20% in 2020.
