The TIPS Spread is a simple comparison between the yield of Treasury Inflation Protection Securities (TIPS) and the yield of conventional U.S. Treasuries with the same maturity date.
Even though these securities have the same maturity date, they have different yields because the payments for TIPS adjust for inflation while the payments for conventional Treasuries do not.
[VIDEO] Monitoring Inflation with the TIPS Spread
The TIPS Spread Can Tell Us A Lot About Inflation Expectations
The TIPS Spread is jam packed with important inflation information. According to the Federal Reserve Bank of San Francisco:
“In principle, comparing the yields between conventional Treasury securities and TIPS can provide a useful measure of the market’s expectation of future CPI inflation. At a basic level, the yield-to-maturity on a conventional Treasury bond that pays its holder a fixed nominal coupon and principal must compensate the investor for future inflation. Thus, this nominal yield includes two components: the real rate of interest and the inflation compensation over the maturity horizon of the bond. For TIPS, the coupons and principal rise and fall with the CPI, so the yield includes only the real rate of interest. Therefore, the difference, roughly speaking, between the two yields reflects the inflation compensation over that maturity horizon.”
The wider the spread between the two yields, the higher investors’ expectations are.
The narrower the spread between the two yields, the lower investors’ expectations are.
Check out this example of a dramatically narrowing TIPS Spread.
Reacting When the Spread Widens
Watching the TIPS Spread, you will be ready to react when the spread widens. To take advantage of that movement, you can buy a TIPS exchange-traded fund (ETF) like the iShares Barclays TIPS Bond Fund (NYSE: TIP) or the SPDR Barclays Capital TIPS Fund (NYSE: IPE) or a TIPS mutual fund like the Transamerica PIMCO Real Return TIPS Fund (NSDQ: IRRAX).