Five Ways to Keep Inflation at Bay

Reassurances from the Fed aren't helping consumers' stretch their paychecks any further, but here are some ways to hedge your investments against inflation

In a speech at an economic research conference on July 10, Federal Reserve Chairman Ben Bernanke seemed fairly optimistic about inflation but said that inflation expectations remain "imperfectly anchored." Unlike 30 years ago, inflation is much less sensitive to things like the persistent spikes in energy prices seen in recent years, the Fed chief said.

So why is that most people feel their salaries aren't buying as much as they did before and that their standard of living is slipping?

So-called core measures of inflation, which exclude volatile food and energy prices, have given some favorable signals on prices recently. But the pinch in their purses that most consumers are feeling from higher gasoline, home heating fuel, and food prices has many of them questioning whether economists have it wrong in saying inflation no longer poses a serious threat.

Wages Aren't Making It

In earlier days, one way people used to hedge inflation was to demand a raise from their bosses. The nonfarm payrolls report released July 6 showed hourly wages were up 3.9% over last 12 months, very little compared with the 2.7% rise in overall inflation year-over-year as of May, says Carl Tannenbaum, chief economist at LaSalle Bank in Chicago. "That's not really much of an increase in most people's living standards. There are a number of reasons labor hasn't had that leverage—the availability of offshoring, production efficiencies that have given managers more control."

The disappearance of wage leverage has given greater urgency for many people to combat inflation another way —through their investment portfolios. The increasing popularity of inflation-protected Treasury bonds, which locks in a real return rate, attests to investors' thirst for relief. The government has been issuing the inflation-adjusted Treasury bonds in ever greater numbers, as have private issuers such as banks, so supply has risen to meet the demand.

And that's just for starters. This week, Five for the Money explores ways that investors can protect their portfolios from the harmful effects of inflation.

1. Treasury Inflation-Protected Securities

Rising inflation is especially harmful to investors in fixed-income securities, as the purchasing power of a bond's principal amount, usually $1,000, is lower at maturity when interest rates are higher than the bond's yield.

Treasury Inflation-Protected Securities, or TIPS, were created in 1997 to enable investors to avoid having the real returns on their bonds eroded by rising inflation and interest-rate levels. The coupon on the bonds is fixed, but investors get an extra kick: The principal amount on TIPS is increased periodically to keep pace with changes in the Consumer Price Index, or CPI. Its interest payment is calculated on the inflated principal, which is eventually repaid at maturity. The yield to maturity on the the 10-year TIPS is 2.71%.

Investors decide whether or not to buy TIPS based on the difference in the yield to maturity they offer and the similar yield on a conventional Treasury bond, which is now at 5.08%. Investors who believe that over the next 10 years inflation will average more than 237 basis points, or 2.37%, should buy TIPS, while those who think inflation will be less than 2.37% should stick with conventional Treasury bonds.

"[TIPS'] break-even rates give investors a way to judge whether they're being fairly compensated in an inflation-linked security vs. a conventional fixed-income security," says Mike Brandes, senior fixed-income strategist at Smith Barney. Even if you don't have a strong conviction about inflation, TIPS are a good way to diversify your bond portfolio to hedge against potential inflation pressures, he adds.

TIPS are subject to federal taxes but are exempt from taxes on the state level.

Because IRAs and other qualified accounts are taxed at ordinary rates when distributed, it makes less sense to put TIPS into those kinds of accounts, says Dan Yu, a senior manager at accounting firm Eisner. "You want to have TIPS in a brokerage or taxable account," he says.

2. TIPS Bond Funds

One disadvantage of owning TIPS individually is that investors are taxed on any increase in principal as if they were receiving it today, even though they won't realize that income until the bond matures, says Matthew Tucker, who heads the investment solutions group at Barclays Global Investors. Investing in bond funds allows people to receive their income in the same tax period in which they're being taxed on it.

"For example, during a year when inflation is high, they could have accumulated a big principal increase but wouldn't actually have accumulated the income to pay for that tax bill," Tucker says.

He suggests investors think in terms of total return, which incorporates any income they receive and the maturity value of the bonds at the end of the holding period.

One popular fund used to hedge inflation is the Lehman TIPS Bond Fund (TIP), an iShares fund launched by Barclays in December, 2003. With $4.4 billion in assets as of July 10, the ETF is benchmarked to the Lehman Brothers (LEH) U.S. Treasury TIPS Index, which includes all 22 TIPS that have at least one year left until maturity, are rated investment grade and have at least $250 million in outstanding face value.

The iShares ETF can provide some transparency regarding pricing and fair value of the securities that isn't usually available to TIPS investors, Tucker says. "It's hard to tell how much the transaction cost will be and how good a price is in the market," he adds.

Michael Shinnick, an equity portfolio manager at 1st Source Bank in South Bend, Ind., prefers actively managed funds, such as the PIMCO Real Return Fund A (PRTNX), an open-end mutual fund with $11.5 billion in assets.

Managers of actively managed funds can "be opportunistic based on how the market is pricing inflation expectations, by buying and selling securities on how tight or wide the spread is on a TIP," he says.

When people want more inflation protection, they will bid those bonds up. "If you have a generous spread and the spread tightens, you're going to pick up extra return, and that's not just hypothetical. It's been done," he says. In an index fund, returns are limited to the level of the CPI factor that's added to the principal each month, he explains.

When interest rates are rising, there is principal risk in a bond fund because the value of a bond with a lower coupon declines as rates increase.

3. Laddering Bonds

Apart from TIPS, if you're investing in individual bonds and have some concerns about inflation, the recommendation is to stay short in duration. One way to do that is to buy what's called a "ladder" of individual bonds that mature at different intervals over time.

"When you ladder bonds, you purchase bonds every six months, so they come due over time, so that if interest rates rise, you can reinvest at higher rates, but you're not trying to time the market," says Smith Barney's Brandes.

Given the difficulty of timing moves up or down in interest rates, laddering bond investments is one of the most effective ways to structure a bond portfolio, because it enables an investor to diversify his or her interest rate risk over time.

If rates fall, the securities you already own become more valuable.

Investors typically create a ladder over a 5- or 10-year time frame, with a portion of them maturing once each year. Besides hedging inflation risks, ladders can also be helpful for parents planning for a child's college education—buying bonds that mature during a future four-year period as a source of cash to pay tuition, Brandes said.

4. Commodity-based Stocks and Funds

Investors can also hedge inflation by betting on stocks of companies that hold reserves of commodities whose prices you believe will continue to rise.

"By owning these companies, you own their reserves of raw materials," Jay Hutchins, president of Comprehensive Planning Associates in Lebanon, N.H., told via an e-mail message.

Sustained spikes in oil prices provide a rationale for owning shares of large oil companies like Exxon Mobil (XOM), for example. Other good bets: companies that handle materials like copper or stainless steel. Stainless steel has been in heavy demand in ethanol plants due to how corrosive ethanol is, according to Tannenbaum at LaSalle Bank.

Farm commodities are somewhat harder to play, but one can benefit indirectly from the price hikes in agricultural products by investing in companies such as Deere (DE) and Caterpillar (CAT) that manufacture farm equipment. These stocks are benefiting not only from higher crop prices, but also from increasing machinery sales internationally, says Tannenbaum.

Commodity-based stocks are also available through mutual funds and ETFs. The Vanguard Materials ETF (VAW) is one that Hutchins recommends using in tandem with iShares' Lehman TIPS Bond Fund and the PIMCO Floating Rate Bonds Fund (PFL), as increases in inflation, interest rates, and commodity prices aren't always in sync with each other.

The Vanguard Materials ETF is comprised of companies of various sizes and tries to track the MSCI U.S. Investable Market Materials Index. At the end of March, the fund's top 10 holdings included Dow Chemical (DOW), Alcoa (AA), Monsanto (MON), and Freeport-McMoRan Copper & Gold (FCX), giving investors exposure to the rising prices of commodity chemicals, aluminum, corn, and copper, respectively. The Materials ETF's market price is up 18.55% since inception in January, 2004.

5. Closed-end Funds

There are also several closed-end funds whose primary objective is to maximize income and capital appreciation over time. Nuveen Investments' (JNC) closed-end funds aren't designed to hedge against inflation, but they end up fulfilling that function by providing superior distributions over time, according to Anne Kritzmire, managing director of closed-end fund product development at Nuveen.

One product is the Nuveen Tax-Advantaged Total Return Strategy Fund (JTA), which blends a strong equity strategy with a corporate bond strategy. Multi-cap value stocks comprise 80% of the fund's holdings, while the other 20% is senior floating-rate corporate loans, which typically aren't available to retail investors.

Kritzmire notes that corporate paper performs especially well in a rising-interest rate environment. Nuveen launched the fund at the end of 2003 in response to the law that reduced tax rates on dividends, focusing on capital appreciation instead.

With $403.2 million in total assets at the end of March, the fund currently trades above $27 per unit, compared with $20 when it was introduced in January, 2004.