Protecting Your Portfolio from Inflation

With consumers and businesses slowly starting to spend again, we expect to see inflation eventually rearing its ugly head. Although the velocity of money (the speed at which money moves through the economy) is still relatively low right now, we expect that to change. The low velocity is mostly due to tight credit, a cautious consumer and high unemployment. However, with a larger portion of the $787 billion stimulus package getting spent over the next six months and consumers spending more (compared to last year) price increases will certainly follow.

There are many ways to protect a portfolio from inflation but unfortunately most come with significant risk and volatility such as commodities, real estate and gold. A better alternative for the risk averse investor may be to consider adding Treasury Inflation Protected Securities (TIPS) to a portfolio. They offer a better risk/reward profile than nominal Treasuries at the current time. TIPS, although interest rate sensitive, are far less sensitive than nominal Treasuries. In addition TIPS have the same credit risk as nominal Treasuries, zero.

Like traditional government bonds, TIPS are a security offered by the U.S. Treasury. However, unlike a nominal Treasury, your interest and redemption amounts are tied to inflation. How a TIP works is a little more complicated than a regular Treasury. The interest rate at the time of issuance remains fixed for the life of the bond. The inflation feature is based on the Consumer Price Index (CPI). The accrued principal value of the bond increases by the amount of inflation. The interest rate is then applied to the inflation adjusted principal value. In the event of deflation, the principal value will fall. At maturity, you will either receive the inflation-adjusted principal amount or the par value of the bond, whichever is greater. Because TIPS are Treasury securities, they are exempt from state and local tax, but investors will owe federal tax on the interest as well as on the increase on the principal value as it accrues. So, there is a “phantom income tax”, due in the year of accrual.

In summary, for the conservative investor in an inflationary environment, TIPS may be a better investment choice over traditional Treasury securities. The primary benefit of owning government bonds is safety. When the markets are in panic mode, fearful investors flock to government bonds. In that scenario, TIPS should hold up similarly to Treasuries. If the markets behave in a more normal manner, we believe TIPS offer a better risk/reward profile than nominal Treasuries and much less volatility than alternative inflation hedges.