LTPZ: Long-term TIPS fund, fully funded dividend yield of 9.0%

Khanchit Khirisutchalual

Earlier this year I wrote about the PIMCO 15+ Year US TIPS Index Exchange-Traded Fund (NYSEARCA:LTPZ), an index ETF that invests in long-term inflation-linked government bonds, or TIPS. LTPZ benefits from increased inflation but is hurt increased interest rates. Lower inflation and higher interest rates would be a particularly negative situation. Since this situation seemed reasonably likely, I spoke out against investing in the fund.

Since then, interest rates have skyrocketed thanks to the Federal Reserve, while inflation remains high. A risk materialized and LTPZ performed more or less as one would expect.

LTPZ Previous article

LTPZ Previous article

Conditions have changed significantly since then, so I thought an update was in order.

Skyrocketing inflation, rising interest rates and lower bond prices have resulted in a significant increase in LTPZ’s dividend yield. The fund currently yields 9.0%, a massive return that is significantly higher than most index ETFs across a broad asset class base and almost entirely backed by underlying income generation. The Fund’s return will fall once inflation normalises, which is almost certain to happen. At current prices, LTPZ should return around 1.5% plus inflation, or 3.5% if inflation hits the Federal Reserve’s 2.0% target. Expected yields are slightly higher than average but not significant.

In my opinion, LTPZ is currently fairly valued and represents a reasonable investment opportunity. I won’t call the fund a Buy as its value proposition is somewhat niche and funds with more stable dividend yields are a better fit for most investors, but the fund is like he is fine.

TIPS Overview

Quick explanation how TIPS, the fund’s underlying assets, work. Feel free to skip this section if you already know all about these securities.

treasury, incl TIPS are the safest assets in the world, backed by the full trust and credit of the US governments. Treasuries offer investors ultra-safe, reliable, albeit low, interest payments and dividends.

TIPS have the added benefit of protecting their dividends, capital and returns from inflation. This is because their face value and coupon payments are linked to the Consumer Price Index or CPI, an index of inflation, when the Index is positive. in simple words, TIPS yields are roughly equal to their interest rate plus inflation.

Let’s explain the above with a quick example.

Suppose you invest $1,000 in TIPS at a yield of 1%, which equates to an interest payment of $10 per year.

If inflation rises to 10%, the value of your investment and your interest will also increase. Your investment would appreciate in value from $1,000 to $1,100 while your interest payment would increase from $10 to $11.

The total return would be $100 plus $11, which is effectively inflation plus the interest rate (10% + 1%). Returns are usually distributed to investors in the form of dividends.

Higher rates of inflation would lead to larger profits and vice versa.

Deflation, on the other hand, has no impact on the value of your investment, interest rates or shareholder returns/losses.

If inflation dropped to -10%, your investment would remain at its $1,000 value and your interest payment would remain at $10. This applies to all deflation rates.

With that in mind, let’s take a look at LTPZ.

LTPZ – overview and analysis

LTPZ is an index ETF that invests for the long term TIPS with an average maturity of 20 years and an average yield of 1.5% plus inflation. The fund has the same characteristics, advantages and disadvantages TIPS and long-term bonds. Let’s take a look at these.

LTPZ – advantages and benefits

Effective protection against inflation

LTPZ’s underlying holdings are all indexed to inflation and therefore see higher dividends, prices and yields when inflation is high and rising.

As most readers are well aware, inflation is rising, hitting a 40-year high earlier in the year. Inflation is elevated due to soaring demand due to improving economic fundamentals, supply issues due to supply chain disruptions, ongoing impact of lockdowns during the pandemic and the Ukraine war. Rising inflation means significantly increased TIPS returns, resulting in higher returns for LTPZ and higher dividends for the fund’s shareholders. The fund currently has a 12-month return of 9.0%, an incredibly strong number.

diagram
Data from YCharts

As seen above, LTPZ’s dividends have grown strongly throughout the year as inflation continues to mount. A full accounting of this growth would mean a lot of higher dividend yields. For example, annualizing the fund’s most recent dividend payment, as SA does, would result in a massive 19.0% return.

LTPZ Dividend Yield

Alpha wanted

LTPZ’s strong dividends are fully funded by the interest and capital gains it generates TIPS holdings, both of which are heavily dependent on inflation remaining high. As such, I wouldn’t consider the fund’s strong dividends itself as an advantage and would instead focus on inflation risk.

Going forward, LTPZ’s dividends are almost certain to fall as inflation will almost certainly normalize sooner or later. The Federal Reserve is targeting a long-term inflation rate of 2.0%, well below the current rate of 8.3%. The Federal Reserve has indicated that current inflation rates are excessive and will raise interest rates until inflation is brought under control. While there is some debate about the speed and effectiveness of Federal Reserve policy, it seems clear that current inflation rates are unsustainable and that relevant regulators will take action until they are brought to more sustainable levels. Therefore, inflation will almost certainly come down in the coming months.

Lower inflation should ultimately result in lower dividends for LTPZ, which is significantly negative for the fund and its shareholders. How much lower depends on how much and how quickly inflation falls, but one can still analyze the situation and make some educated guesses.

According to the US Treasury Department, LTPZ’s underlying holdings are long-term TIPS with a remaining maturity of around 20 years have an average yield of 1.5% plus inflation. The Federal Reserve is targeting a long-term inflation rate of 2.0%. Assuming that goal is met, LTPZ’s dividend yield should drop to around 3.5% in the coming years. If inflation lasts longer than expected, as has been the case so far, the fund’s strong dividends should continue as well.

as a final point, The TIPS yield is currently slightly higher than in the past. According to the US Treasury for the last decade long-term The TIPS yield has averaged 0.6% plus inflation, while the same securities are currently yielding 1.05% plus inflation. It’s a small difference, but not insignificant, and one that will benefit LTPZ and its investors.

Low credit risk

LTPZ invests exclusively in government bonds, the safest securities in the world, backed by the full trust and credit of the United States federal government. Credit risk is virtually zero barring an unprecedented US government default. LTPZ’s holdings are incredibly safe securities, a significant benefit to the fund and its shareholders.

LTPZ holdings also outperform during downturns and recessions due to the flight to quality effect. Investors know government bonds are safe, so they flock to government bonds when times get tough. Monetary policy also plays a role, as the Federal Reserve tends to lower interest rates during downturns and recessions, pushing bond prices higher and leading to capital gains for bond funds, including LTPZ. Expect the fund to outperform during downturns and recessions, as it did in the first quarter of 2020, the start of the coronavirus pandemic. LTPZ likely underperformed normal long-term Treasuries the Best-performing asset class during most recessions.

diagram
Data from YCharts

LTPZ – risk and negatives

interest rate risk

LTPZ invests in long term TIPS, which like most long-term bonds carry quite a bit of interest rate risk. The fund itself has a duration of 20 years, so there should be a 20% capital loss for every 1% rate hike, a staggering amount. Long-term interest rates are up about 2% year-to-date, according to the 20-year Treasury, for which the fund would have had to take capital losses of about 40.0%. Realized losses were slightly lower at 36% due to increased inflation.

diagram
Data from YCharts

LTPZ’s significant interest rate risk could result in excessive capital losses if interest rates continued to rise, which would be materially negative for the Fund and its shareholders.

inflation risk

LTPZ stocks see higher dividends and yields as inflation rises, a positive, however lower Dividends and yields with inflation sinks, A negative. With inflation at a multi-decade high and the Federal Reserve intending to dampen inflation, inflation will almost certainly fall in the coming months, which is negative for the Fund and its shareholders. LTPZ could still offer reasonably good dividends if inflation stayed high longer than expected, a definite possibility, but current dividend yields are almost certainly unsustainable over the long term.

Conclusion

LTPZ offers investors a long-term commitment TIPS, securities that generate strong capital gains, dividends and yields when inflation is high. With inflation currently high, the fund offers investors strong dividends and potential returns. If inflation normalizes, both should fall. Assuming inflation eases to its long-term target of 2.0%, LTPZ’s dividend yield should fall to about 3.5%, slightly higher than its historical average yield. Under these conditions, the fund appears appropriately valued and represents a fair investment opportunity.

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