Inflation-Protected Securities – What You Need To Know

Inflation is low right now, but it won’t stay that way forever.  At some point, inflation will heat up and that might cause interest rates to go up. So what’s an investor to do?  Glad you asked.

Some people think that the only way to go is to buy government bonds which are tied to inflation.  That way if rates do go up, their capital and income are protected.  This is indeed one option (which will be discussed) but it’s far from the only alternative.  Be open-minded. We’ll take a look at TIPS certainly, but as you’ll see, bonds aren’t the only choice if you want an inflation hedge.

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” – and acts as a sort of investment insurance.   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.

So if you think rates are going to go up you might go for this kind of fund. But to be frank I don’t think this is the best way to achieve the goal of having good stable retirement income. 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 suggest doing. 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 I mentioned above.  TIPS 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 need a little growth to combat inflation.  TIPS investments probably won’t give you that growth Pilgrim.  Sorry.

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 are low right now, it’s potentially a decent time to buy despite the fact that prices have already risen in many parts of the country. If you have a 10-year time horizon, I believe real estate is something 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.

Gold is one commodity that people think of when it comes to battling inflation but it isn’t the only game in town.  And if you do want to buy commodities, you can find many mutual funds and ETFs that only invest in very specific commodities.  Now for the bad news.

Commodities have always been an investment area known for speculation. I’ve never liked gold for this exact reason.  When all hell was breaking loose in 2008 gold sailed to over $1900 an ounce.  You couldn’t turn your radio on without hearing a sales pitch for the stuff.  Now, 5 years later, the price is a bit over $1100 an ounce. Ouch.

All commodities are 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.   “No bueno”.

5. Growth Funds

Some people buy growth mutual funds to generate income.  I like this approach very much for long-term investors.  It’s not guaranteed of course.  But over time, it can potentially help investors grow their income and their account values.  Yummy.

But this isn’t a silver bullet.  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.

Inflation, when it comes, can be a threat to your investments and income if you aren’t prepared.  Take time to understand your alternatives and work out a comprehensive investment plan you’ll stick to even when rates and inflation starts heating up.

What are you doing to protect yourself from inflation?