Investing for Inflation Protection

Last year I recommended TIPS funds as particularly attractive for tax-exempt investment accounts.

TIPS have gained substantially since then, but from a historical perspective the current 10-year TIPS break-even rate of 2.1% is still low. (“Break-even” is the realized inflation rate above which an inflation-protected security will pay more than its non-inflation-protected equivalent. In the case of TIPS that would be regular treasury bonds. A break-even rate of 2.1% means that ). Since inflation protection is valuable insurance in a market like this, with low current inflation but exploding money supply (which could easily lead to surprisingly high inflation in the next few years), one might expect TIPS break-even rates to run above the long-run expected inflation rate, which is around 2% per year. Indeed, it is still cheaper to buy TIPS than to buy treasuries and hedge against inflation with options.

However, as I noted earlier, TIPS aren’t a perfect inflation hedge. Bill Tedford, a successful treasury bond portfolio manager and inflation bug, has other ideas on investing for protection against inflation:

In his own portfolio, Mr. Tedford has begun shorting 30-year Treasurys, expecting the prices to fall as interest rates begin to rise. For clients, however, Stephens is encouraging the use of exchange-traded funds to own exposure to real assets. Mr. Tedford says a 5% or 10% position overall “is big enough to protect a larger portfolio.”

Among ETFs, Stephens likes the U.S. Gasoline Fund, the iShares Dow Jones U.S. Oil & Gas Exploration & Production Index, SPDR Gold Trust, PowerShares DB Base Metals Fund and the PowerShares DB Agriculture Fund. The firm also likes Plum Creek Timber Co.

Though Treasury inflation-protected securities, or TIPS bonds, would seem a natural bet, Mr. Tedford says his group just this month sold off its TIPS investments. Real yields on TIPS are barely above 1% now and Mr. Tedford expects those yields will increase as inflation mounts, hurting prices, which move in the opposite direction.

The likely result: “The return on your TIPS could fall 10% or 15%,” basically wiping out the bond’s inflation protection.

I would personally steer clear of gold as an inflation hedge because it is particularly prone to speculative bubbles, and has less intrinsic value than most other commodities. But diversified investments in energy, industrial metals, and the agricultural sector should also serve as good long-term inflation hedges.

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