New Inflation / Deflation ETNs: Better Than TIP?

by on December 7, 2011 | Updated May 14, 2013 | ETFs Mentioned:

PowerShares and Deutsche Bank, partners on a suite of exchange-traded notes targeting commodities and several international bond markets, have rolled out a pair of ETNs designed to target changes in inflation expectations. The new notes will be linked to indexes that are designed to measure the market’s expectations of future inflation implied by the difference in yields between a position in U.S. TIPS and an offsetting position in Treasuries with approximately equivalent terms to maturity. The new ETNs include: 

  • PowerShares DB US Inflation ETN (INFL): This note is linked to the DBIQ Duration-Adjusted Inflation Index, which consists of a long position in TIPS and a short position in Treasuries with approximately the same duration.

Better Than TIPS?

To understand the objectives of these new products, it is useful to consider the impact that changes in the market’s expectations on inflation will have on asset prices. When investors’ inflation expectations increase (i.e., they believe future inflation will be greater than previously predicted), TIPS should outperform otherwise similar Treasuries. When expectations for future inflation decline, Treasuries should perform better than inflation-protected bonds. By using a long / short approach, these new ETNs will essentially isolate the component of returns attributable to changes in expectations of inflation–without exposing investors to the various other factors that can impact the value of fixed income securities.

The massive injections of capital into the global financial system in recent years have led to increased anxiety over the prospect of heightened inflation in coming years, since increases to the money supply tend to eventually cause increases in CPI. Many investors have turned towards inflation-protected bonds, or TIPS, as a means of protecting assets from the adverse impact of inflation. Generally, the principal value of TIPS adjusts with changes in CPI; if inflation accelerates, the value of a the maturity payment due to investors also climbs.

ETFs have become a popular tool for accessing TIPS; there are now a dozen ETFs in the Inflation-Protected Bonds ETFdb Category with aggregate assets of more than $25 billion (the lion’s share of that total is in TIP). But despite the tremendous popularity, there are some potential limitations as inflation hedges–which could cause investors some unexpected pain in coming years. For starters, inflation-protected bonds are still bonds–which means that values tend to decline when interest rates rise. Because inflationary pressures often lead to rate hikes, there can be obvious drawbacks to holding TIPS in inflationary environments [see 25 ETFs To Combat Inflation].

Because the new ETNs combine long and short positions, the interest rate risk of these products is essentially zero. By stripping out this component, the new “inflation ETNs” isolate returns that are attributable primarily to changes in expectations of future inflation while eliminating other noise that contributes to returns of more traditional inflation hedges. That makes INFL a potentially much more useful tool for adding inflation protection to a portfolio than TIP or other ETFs that maintain only long positions in inflation-protected bonds [see Inflation: A Threat To Your Portfolio?].

“We are pleased to expand our successful exchange-traded platform to now include TIPS-based products,” said Martin Kremenstein, Chief Investment Officer of db-X North America. “By establishing an offsetting position in U.S. Treasuries and neutralizing the impact of changes in the interest rates, we believe the PowerShares DB US Inflation and Deflation ETNs can more effectively target long or short exposure to inflation for investors.”

Inflation ETF Options

In addition to the various ETFs focusing on inflation-protected bonds, there are a number of other products that are designed to function as inflation hedges. WisdomTree offers an actively-managed Global Real Return Fund (RRF) that combines inflation-protected bonds with various commodities, while IndexIQ’s Real Return ETF (CPI) holds a core of short-term bonds surrounded by other asset classes.

Disclosure: No positions at time of writing.