SCHP ETF: Significant Volatility Makes It A Hold (NYSEARCA:SCHP)

The Schwab U.S. TIPS ETF (NYSEARCA:SCHP) offers investors exposure to medium-term treasury inflation-protected securities, or TIPs. As is the case for most treasuries, credit risk is close to zero, while interest rate risk is a bit higher than average. Unlike most treasuries, SCHP is hedged against inflation, and currently yields around 2.0% plus inflation, equivalent to 5.5% as per last month. It is a reasonably good yield, and inflation-protected to boot.

Although SCHP has many important benefits, its dividends and share price are simply too volatile, even after taking into consideration inflation volatility. As such, I would not be investing in the fund right now.

TIPs Overview and Explanation

SCHP is an index ETF investing in U.S. treasury inflation-protected securities, or TIPs. These securities are a bit niche, so thought to start with a quick overview and explanation of these. Feel free to skip this section if you already know all about TIPs, or if you’ve read my previous articles on the subject.

Treasuries, including TIPs, are the safest assets in the world, backed by the full faith and credit of the U.S. governments. Treasuries offer investors ultra-safe, dependable, albeit low, interest rate payments and dividends.

TIPs have the added benefit that their dividends, capital, and returns, are protected against inflation.

TIPs are protected against inflation, as their face value and coupon rate payments are indexed to the Consumer Price Index, or CPI, an inflation index, for positive values of said index. In simple terms, TIPs returns are roughly equal to their interest rate plus inflation.

Let’s explain the above with a quick example.

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

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

Total returns would be equal to $100 plus $11, effectively equivalent to inflation plus interest rate (10% + 1%). Returns are generally distributed to investors in the form of dividends, but higher rates of inflation would lead to greater gains and vice versa.

Deflation can impact the value of your investment and dividends, but can never cause these to decrease below their original level. In the example above, deflation of 10% could cause your investment to drop in value from $1,100 to $990, but not from $1000 to $900. In other words, deflation can reduce gains, but never lead to net losses.

With the above in mind, let’s have a look at SCHP itself.

SCHP – Basics

• Investment Manager: Schwab
• Expense Ratio: 0.04%
• TIPs Yield: 2.0% plus inflation
• TTM Yield: 4.0%
• Total Returns CAGR 10Y: 5.26%

SCHP – Benefits and Investment Thesis

Extremely Low Credit Risk

SCHP invests in treasuries, issued by the U.S. Treasury, and backed by the full faith and credit of the U.S. government. Credit risk is effectively nil, barring an unprecedented U.S. government default. SCHP’s extremely low credit risk all but ensures long-term capital stability, a benefit for shareholders. Low credit risk also serves to minimize losses during downturns and recessions. As an example, SCHP suffered approximately no losses during 1Q2020, the onset of the coronavirus pandemic. Vanilla treasuries performed much better, however.

Inflation Protection

SCHP’s dividends and returns are strongly linked to inflation, with higher inflation directly and necessarily leading to higher total returns. Excess returns generally take the form of dividends, but there is quite a bit of volatility here. SCHP’s dividends grew from mid-2021 to late 2022, as inflation skyrocketed, but have declined since, as inflation normalizes.

SCHP is protected against inflation, a straightforward benefit for investors. Although inflation has mostly normalized by now, it remains above target, reaching 3.7% this past August. Inflation has actually accelerated these past few months, but monthly figures are quite volatile, so this does not necessarily mean all that much.

SCHP’s inflation protection is a small but impactful benefit for investors right now, and serves as an important hedge for long-term investors.

Good Dividends and Returns

SCHP’s underlying TIPs currently yield around 2.0% plus inflation, across maturities. Data as per the U.S. Treasury, figures below are without inflation.

As per SCHP, the fund’s underlying holdings generated around 5.5% in income last month. Of that 5.5%, around 3.7% came from inflation, and the other 2.0%% from coupon payments from the TIPs. The 0.2% difference is due to volatility, expenses, and as some of these figures are from slightly different time periods.

Do remember that TIPs currently yield around 2.0% plus inflation. It all adds up, plus or minus 0.2%.

SCHP’s dividends are currently much higher than their historical averages on both a nominal basis:

and on a real basis:

SCHP’s current dividends seem reasonably good, especially considering the fund’s extremely low credit risk and inflation protection.

Possible Investment Thesis / Target Market

SCHP’s characteristics seem particularly important and beneficial for more long-term conservative investors and retirees. These can invest in the fund without worrying too much about credit risks, defaults, inflation, cost of living, or their long-term capital. SCHP does have some interest rate risk, but this is less of a concern for more long-term investors. SCHP’s dividends are not the highest, but they are reasonable enough.

By my calculations, and assuming TIPs yields of 2.0% plus inflation, investors in SCHP can safely withdraw around 4.0% from the fund every year, adjusting for inflation, for several decades before running out of money. Higher withdrawal rates seem to work too. This does assume no significant changes in interest rates, share prices, or volatility, however.

From the above, it seems that SCHP is a reasonable investment opportunity for more conservative, risk-averse long-term investors and retirees. The fund’s many risks and downsides make me uncertain that this is the case. Let’s have a look at these.

SCHP – Risks and Downsides

Structural Issues

SCHP’s underlying holdings are structured in such a way as to make them somewhat unsuitable securities for income investors.

Specifically, inflation mostly increases the price of TIPs, not their dividends, yields, or coupon payments. Although funds focusing on these securities tend to distribute these price gains to shareholders as dividends, the situation is complicated, and somewhat murky. Dividends tend to be insanely volatile too.

Importantly, dividends are more volatile than expected from prevailing inflation rates, and sometimes these two variables move in opposite direction. As an example, the fund paid no dividends from January 2023 to March 2023, and only paid a tiny dividend in April, even though inflation was quite elevated earlier in the year. It was, in fact, higher when dividends were at zero.

As another example, the fund’s latest dividend annualizes to 3.8%, even though the fund generated around 5.5% in income last month, as per its SEC yield.

SCHP’s dividend volatility is a negative in and of itself, and it also serves to reduce the effectiveness of its inflation protection. Inflation was a bit high in early 2023, but investors received no dividends, and the same could be true in future inflationary periods.

Notwithstanding the above, TIPs are structured so as to benefit from higher inflation. SCHP sometimes chooses to retain these benefits within the fund / within the securities themselves, an obvious negative for income investors, less so for those looking for long-term total returns.

Interest Rate Risk

SCHP focuses on medium-term treasuries with moderate interest rate risk, and a duration of 6.7 years. SCHP should see moderate losses when interest rates are rising, as has been the case since early 2022. The fund’s inflation protection did somewhat reduce these, however.

SCHP’s moderate interest rate risk is a negative in and of itself, and also reduces the effectiveness of the fund’s inflation protection. SCHP’s TIPs did see higher prices, dividends, and returns as inflation rose, but these were completely overwhelmed by losses from higher rates.

The issue above compounds with the fund’s volatile dividends. If dividends were more stable, and more tightly linked with inflation, investors might choose to ignore these price fluctuations, and focus on dividends and long-term returns instead, neither of which is negatively impacted by higher rates. Right now, ignoring short-term price movements means ignoring the fund’s inflation hedge, one of its key selling points.

As a final point, the issues above make it very difficult to use SCHP as an inflation-protected income vehicle. The income is too volatile, and the inflation protection gets overwhelmed by interest rate movements in the short-term. Investors focusing on long-term total returns might be willing to overlook these issues, shorter-term or income investors less so. At the same time, these issues make it difficult to put the following table in practice:

If dividends are 2.0% plus inflation, then it is easy to withdraw an extra 2.0% every year, plus portfolio values should not decrease excessively from doing so. If dividends are, well, something else, it becomes much more difficult to time or quantify the withdrawals necessary, plus these might end up jeopardizing portfolio values.

Conclusion

SCHP offers investors exposure to medium-term treasury inflation-protected securities, or TIPs. SCHP currently yields around 2.0% plus inflation, and provides investors with a few other benefits. Although the fund has many important benefits, its dividends and share price are simply too volatile, even after taking into consideration inflation volatility. As such, I would not invest in the fund.