Inflation-Protected Securities – What You Need To Know

Investors should take a look at inflation protected securities these days. But while doing so, I suggest you remain open-minded. We’ll take a look at TIPS certainly, but as you’ll see, bonds aren’t the only alternative if you want an inflation hedge. The trick is to safeguard your capital and inflation-hedge your income. Not an easy feat.

And when it comes to bonds, you really want to tread lightly. Investors have been getting out of equity funds and into bond funds (and preferred shares) in search of better yield. If you do that, you might get smacked when interest rates rise with inflation. As you know, the price of bonds drop as interest rates rise. That’s just how bonds work.

Of course, nobody knows when interest rates will go up, but most people agree they can’t get much lower than they already are. So what are people doing to protect themselves against inflation?

Before we get started, keep in mind that this post is for your information only. Don’t rely on this for investment advice. Talk to your investment advisor to make sure if any of the following are appropriate for you before investing.

1. Long and Short Bond Funds

There are a number of mutual funds that buy bonds and, at the same time, sell bonds they don’t own. This is known as “shorting.” They short the bonds because the fund manager thinks the values of those particular bonds will decrease. If they are right and values do decline, the manager can buy back the bonds at a lower price sometime in the future. That’s what “shorting” is all about.

This is a strategy I don’t like it if you are looking for good retirement income investments. It’s extremely risky. If you buy a long/short fund, you’re betting on the managers’ ability to predict the future, and that’s something I never want to invest in. While this is a strategy that hedge funds have used for years, it’s relatively new for mutual funds and not one recommended for risk-averse investors.

2. TIPS

Another favorite are TIPS – which stands for Treasury Inflation-Protected Securities. If inflation heats up, the principal invested in a TIPS bond increases. If deflation sets in, the principal decreases.

Once your TIPS matures, you receive the greater of what you invested or the adjusted value. These bonds pay interest twice a year at a fixed rate. And if your principal rises because of inflation, so do your interest payments. Of course they also decline with deflation. Inflation and deflation are measured against the consumer price index.

I’m not a huge fan of TIPS for the long run either. Yes, TIPS are a form of US Treasury and as such are still considered one of the safest investments in the world. But as a result, they don’t pay that much interest. Basically you’ll earn the inflation rate plus a little for your trouble. Not a great way to grow your wealth, if you ask me. Even if you are retired now, you still a little growth to combat inflation that may come and compound over your lifespan.

And my last note on TIPS is that while rates may be heating up, they could simmer for a very long time. Investors interested in making smart retirement investments should think twice before buying TIPS as a long-term investment strategy.

3. Real Estate

Real estate could be a great inflation-fighting investment right now. If you buy the right property, you’ll receive rent while you hold the property. Since mortgage rates and prices are low right now, it’s potentially a great time to buy. If you have a 10-year time horizon, I believe real estate is an area to consider if you want to beat inflation. Just the same, when you buy real estate, it’s like owning a small business. Be prepared.

4. Commodities

Commodities are tangible goods that aren’t branded products. In other words, oil, corn, wheat, silver, platinum and gold are all examples of commodities. You don’t buy “designer” corn. You just buy corn.

Commodities are considered inflation hedges because as the currency becomes weak, it costs more dollars to buy the same amount of the commodity. The real story over the last several years has been commodities, in fact, with many commodities reaching multi-year highs.

Gold isn’t the only commodity game in town. As a matter of fact, you have much better alternatives than gold if you are interested in commodities, and you can find many mutual funds and ETFs that only invest in very specific commodities.

Before you do this, however, a word of caution. Commodities have always been an investment area known for speculation. Gold is at an all-time high partly because of inflation, but partly because of the hype and speculation.

And commodities are also subject to market swings and, in many cases, natural forces. Cotton, wheat, sugar and coffee are all commodities, but each might be impacted significantly by weather conditions, and that could turn a wining investment strategy into a big loser.

5. Growth Funds

Mutual funds that buy good growth stocks could do really well in a moderate inflationary period. In fact, that might be what investors are seeing right now. Remember, even though the market has recovered, the 10-year return is still far below the typical 10-year return. That has given many investors reason to think that the market still has some catching up to do and they could be right. Also, some funds own stocks that pay dividends, and that is a nice bump to your total return.

But if inflation gets out of control, the market might not do that well. Remember that share values are determined by the earnings a company makes. If inflation heats up, that might result in greater profits, which would lift the value of the shares. But if it results in lower earnings because of increased costs, the shares might drop.

The stock market remains a great alternative for long-term investors. Don’t forget about it to help you protect against inflation.

What are you doing to protect yourself from inflation?