Inflation protection: weigh your options
By Richard A. Brink, CFA
Given the dominance of inflation in today’s capital market debate, anyone watching this video shouldn’t be surprised that one of the most common questions I get is, “How can I protect my against inflation? And that’s what we’re going to focus on today: what to think about when you think about inflation protection.
So let’s start with the obvious, how effective is a hedge? We have done additional research on real assets, for example, and there are three lenses through which we judge the effectiveness of these hedges. The first is reliability, how consistent is this investment as an inflation fighter over time? Second, scale. We call it the “inflation beta”. How much does this investment move when inflation appears? And then the third, and this is really important, is cost-effectiveness. So, for example, in stocks, if I tried to search for a segment of the stock market with a history of inflation protection, I could find it. I was just talking about real assets. What about the stocks of real asset or value producers, which typically tend to do well in inflationary environments?
However, we believe that much of the heavy burden of inflation protection lies more at the business level, in a company’s ability to navigate an inflationary environment, navigate price increases , and this allows us to not become too focused in researching sectors and instead be diversified and also maintain broad exposure to market returns. Again, in pursuit of inflation protection with broad market exposure.
The same with fixed income securities. Implicitly speaking, I can just add credit if I want to try to add some level of inflation protection. Why? Because one of the best ways to beat rising yields for whatever reason is to outrun it. This provides me with both a yield buffer and if this inflation occurs in a reasonably strong economic environment I may also have capital gains through spread compression within credit, both count. But there is another aspect, which is explicit protection within the fixed income world. And many of you know all about it, folks. Outside the United States, these inflation-linked securities are often referred to as “linkers”, and inside the United States they belong to the MIPS family. MIPS, Municipal Inflation Protected Securities, and on the taxable side, Treasury Inflation Protected Securities or TIPS. If you take a nominal treasure or a garden variety, and think about the coupon, it’s basically split into two things. One is the amount of compensation you receive from the government for lending them money. The real yield. The second is an offset for expected inflation over the life of the bond so that your initial investment retains its purchasing power throughout maturity. But it’s kind of a do-it-yourself project because, in theory, you’re supposed to take that share and reinvest it into your own principle in order to retain that buying power.
Where TIPS security comes in is that the government does it for you. You only receive the actual return and instead the government adjusts your principal over time based on actual inflation. So the real benefit is that it is self-explanatory, but there are limiting factors inside the TIPS world. The first is the main TIPS index that a lot of people gravitate towards has a very long duration, and it’s kind of sneaky because it creates a frying pan and fire scenario, because maybe I’m going out of the pan to fry in order to escape the risk of inflation, but am I plunging headlong into the fire? Because now I’m taking a very long duration profile which translates to a lot of interest rate risk just as a Federal Reserve starts to tighten, reducing its bond purchases in an effort to raise interest rates. ‘interest.
So how could I defend myself against that? Well, I have another obvious suggestion for you, buy shorter maturity TIPS. Now, again, classically we think of an index and gravitate around it, but the reality is that the inflation protection for a 30-year TIP or a 1-year TIP is the same. Thus, you have the power, if you wish, to modulate your exposure to interest rates. And if you wish, pair it with your current duration profile inside your wallet, however, no matter what, there are always limiting factors in the world of TIPS, one of which is the phantom income. This inflation adjustment you receive, you have to pay taxes every year, even if you haven’t received it yet.
And the second and probably much more important part is again, there’s an opportunity cost here. Yields and treasuries are incredibly low. So let’s say I have a core plus portfolio that is yielding 2%, and I decide to migrate, sell that, and switch to a cash-only portfolio, where the yield drop is significant. And remember, we talked about credit earlier. Even in a world where inflation was only 2%, returns are so low that credit is essential just to produce returns above the rate of inflation at a normalized level. So wouldn’t it be nice if I could be exposed to the credit I talked about earlier, but still have a way to access inflation protection? And that brings me to the third point of discussion, which is CPI trading. Now, in this video, we don’t have enough time to go over how weird swaps work, but on a high level, I want you to think of it as wrapping around a wallet.
So ideally I would be able to have a diversified portfolio of fixed income with government and corporate bonds and I could additionally add that envelope around it. And in theory, CPI swaps let you do that. Now they don’t do it for free. It costs about 15 to 25 basis points of yield for this swap. But again, if I start from a higher base yield level and subtract that cost, I’m still likely to easily outperform the yield on government securities alone, and clearly that’s significant. And of course, IPC swaps aren’t bulletproof either because they adjust your principle up or down based on changes in inflation expectations up or down. But it’s a great tool for investors trying to navigate price movements over time, protect real buying power, and maintain yield.
So if I zoom out to sum it all up it comes down to this, whenever I choose an investment as an inflation hedge I look for two things, its effectiveness as an inflation hedge in the presence of inflation, but also its performance as an asset in itself in its absence. If we can manage this mix, then we can get the best of both worlds. To participate in a market that must be reasonable in the future, but also to hedge against the risks of inflation that we all face today. If you have any further questions, please, because we’ve covered a lot of information here, contact your AllianceBernstein representative, but in the meantime, thank you very much for reaching out.
Editor’s note: The summary bullet points for this article were chosen by the Seeking Alpha editors.