Investors have been flocking to the safety of treasury bonds in recent months as volatility in stocks has pressed interest rates markedly lower. In many instances, this has caused traditional treasuries to rally near the top end of their 52-week highs and may indicate a greater risk of rich valuations fighting with waning momentum. Nevertheless, one area of the Treasury market has just started to perk up and may be signaling further strength on the horizon.

Treasury Inflation Protected Securities or TIPS are government bonds whose face value increases with inflation. While most investors confuse this concept with rising interest rates, TIPS are designed to adjust in relationship to the Consumer Price Index as a measure of inflationary forces.

The iShares TIPS ETF (TIP) is a well-known proxy of this niche income asset class. This ETF tracks a basket of 38 TIPS securities and has over $14 billion in total assets. TIP has an effective duration of 7.51 years, which is similar to the interest rate sensitivity of the iShares 7-10 Year Treasury ETF (IEF).

As you can see on the 5-year chart below, these two funds tracked each other fairly closely until the 2013 taper tantrum and subsequent dip lower in interest rates.

Moreover, the October 2014 time-frame marked an important inflection point in CPI that likely impacted the TIPS theme as consumer prices experienced a pronounced contraction.

Since January of last year, we have seen inflationary forces once again trend higher, but very little forward progress in TIP securities. This may represent an interesting value opportunity for income investors looking for dislocations in the market.

TIP recently broke above its 200-day moving average, which is an encouraging technical sign of building momentum. In addition, this ETF is still 8% off of its all-time high set near the 2012 peak.

Continued strength in this index is going to have to be built on several factors:

1. Continued falling or stable intermediate-term interest rates.
2. A picking up of inflationary forces, which may coincide with a rebound in commodity prices.
3. A change in sentiment towards one of protecting against the rising cost of goods and services rather than worries over deflationary pressures.

It may seem like a stretch to imagine that inflation will once again rear its ugly head in the face of so much pessimism in the stock market. However, a rebound in commodity prices, continued strength in the housing market, and overall expansion in the labor metrics may play a role in developing this theme.

It should be noted that TIPs are very much a specialized corner of the Treasury market and may be better served as a tactical opportunity rather than a core holding. This sector could be used to supplement your existing fixed-income positions and provide nuanced exposure with the potential for outperformance given the relative dislocation to traditional treasuries.

Income investors should also be aware that a fund such as TIP pays a lumpy income stream because of the small pool of issuance. As a result, this ETF won’t exhibit the normal steady monthly income that most bond funds deposit in your brokerage account. This is one more reason why this fund may prove to be more appropriate as smaller allocation designed to take advantage of an emerging tactical opportunity.

The Bottom Line

Jeffrey Gundlach has famously declared on numerous occasions that “TIPs are for losers” and over the last several years he has certainly been right on that account. Nevertheless, this unique sector should still be on your radar and may warrant closer attention over the next several months.

Bonds typically move at a much slower pace than stocks. Therefore, taking a patient approach with the mindset of stalking a new trend may be your best game plan in this instance.