Inflation Expectations
Inflation can damage your portfolio in two primary ways. Expectations of future inflation are one of the main drivers of financial market behavior. If inflation expectations suddenly jump in the wake of a spike in oil prices, bond prices may plummet. Their link to the markets comes from the second way inflation hurts investors: It depresses the value of fixed income instruments, such as bonds and loans, because it makes the cash flows they throw off less valuable.
Often those who seek to hedge their inflation risk are advised to simply increase their allocation to equities. The assumption is that stocks will rise in inflation-adjusted terms because companies are free to raise the prices of goods and services to keep pace with inflation. Unfortunately, this is a misconception. Corporate profits are the difference between the cost of raw materials and the cost of finished goods, and since inflation typically originates in the raw materials sector, corporations can't raise prices until margins are squeezed down. That means profits have a hard time doing well in an inflationary environment.
As investors have realized that equities are an imperfect shield from inflation, there has been growing demand for products designed especially to hedge this risk. The most popular is the U.S. Government-issued TIPS - Treasury Inflation Protected Securities. But there are also new mutual fund, managed account, structured product and derivitives instruments on offer that may be of use to private investors.
The government began issuing TIPS in 1997, and it is now a mature and easily accessible product. Government-issued TIPS are the most realistic option for a lot of investors. TIPS have a payoff that changes in line with the CPI for urban areas (CPI-U), published monthly by the Bureau of Labor Statistics. They perform well in a rising interest rate environment, but usually underperform other government bonds when inflation falls or is stagnant. Despite the low level of inflation in recent years, it has been enough to boost the otherwise anemic performance of this instrument.
Just as with ordinary Treasury securities, TIPS pay a coupon that is a fixed percent of the principal amount. Unlike conventional bonds, however, the TIPS principal value is adjusted to reflact changes in the CPI-U. That means their price is very different from conventional Treasuries. As with a conventional bond, changes in the behavior of interest rates will also affect the relative performance of TIPS. And because these instruments have a very low risk profile, portfolio managers suggest they be used as the foundation for a fixed-income portfolio.
There are other methods of ensuring a real return on investments. One simple way is to invest in a real return mutual fund or managed account. Some of these invest in TIPS and other international inflation-linked government securities. Pimco manages a real return fund that is mostly invested in TIPS, but also includes other assets such as high yielding emerging market bonds. Another type of mutual fund/managed account invests in commodities or securities that track commodity prices, because these tend to rise in an inflationary environment. Real return funds typically charge a 3 to 4 percent sales charge.
Another tool for hedging inflation is a structured note with an inflation-linked payoff. With something like this, an investor can purchase an investment tied to the performance of the Dow Jones AIG commodity index, in which the initial investment principal is guaranteed, so the instrument has very little risk. Index-linked products of this nature typically offer an investor some percentage of any positive move in the index.
Most people believe that inflation remains tame at this time. But the growing pressures in the housing and energy markets, along with the falling dollar and the fact that the Federal Reserve is crippled from raising rates too much by fears it will harm the economy, raise legitimate concerns about its reappearance. Individual investors who worry about its caustic effects on a portfolio now have a variety of tools to manage it, while earning a respectable return.
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Often those who seek to hedge their inflation risk are advised to simply increase their allocation to equities. The assumption is that stocks will rise in inflation-adjusted terms because companies are free to raise the prices of goods and services to keep pace with inflation. Unfortunately, this is a misconception. Corporate profits are the difference between the cost of raw materials and the cost of finished goods, and since inflation typically originates in the raw materials sector, corporations can't raise prices until margins are squeezed down. That means profits have a hard time doing well in an inflationary environment.
As investors have realized that equities are an imperfect shield from inflation, there has been growing demand for products designed especially to hedge this risk. The most popular is the U.S. Government-issued TIPS - Treasury Inflation Protected Securities. But there are also new mutual fund, managed account, structured product and derivitives instruments on offer that may be of use to private investors.
The government began issuing TIPS in 1997, and it is now a mature and easily accessible product. Government-issued TIPS are the most realistic option for a lot of investors. TIPS have a payoff that changes in line with the CPI for urban areas (CPI-U), published monthly by the Bureau of Labor Statistics. They perform well in a rising interest rate environment, but usually underperform other government bonds when inflation falls or is stagnant. Despite the low level of inflation in recent years, it has been enough to boost the otherwise anemic performance of this instrument.
Just as with ordinary Treasury securities, TIPS pay a coupon that is a fixed percent of the principal amount. Unlike conventional bonds, however, the TIPS principal value is adjusted to reflact changes in the CPI-U. That means their price is very different from conventional Treasuries. As with a conventional bond, changes in the behavior of interest rates will also affect the relative performance of TIPS. And because these instruments have a very low risk profile, portfolio managers suggest they be used as the foundation for a fixed-income portfolio.
There are other methods of ensuring a real return on investments. One simple way is to invest in a real return mutual fund or managed account. Some of these invest in TIPS and other international inflation-linked government securities. Pimco manages a real return fund that is mostly invested in TIPS, but also includes other assets such as high yielding emerging market bonds. Another type of mutual fund/managed account invests in commodities or securities that track commodity prices, because these tend to rise in an inflationary environment. Real return funds typically charge a 3 to 4 percent sales charge.
Another tool for hedging inflation is a structured note with an inflation-linked payoff. With something like this, an investor can purchase an investment tied to the performance of the Dow Jones AIG commodity index, in which the initial investment principal is guaranteed, so the instrument has very little risk. Index-linked products of this nature typically offer an investor some percentage of any positive move in the index.
Most people believe that inflation remains tame at this time. But the growing pressures in the housing and energy markets, along with the falling dollar and the fact that the Federal Reserve is crippled from raising rates too much by fears it will harm the economy, raise legitimate concerns about its reappearance. Individual investors who worry about its caustic effects on a portfolio now have a variety of tools to manage it, while earning a respectable return.
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posted by Bob Moser at
5:35 PM
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