What options are there for a low-risk hedge against inflation if I believe that Treasury Inflation Protected Securities (TIPS) aren't working?

July 7, 2008 5:49 AM

What options are there for a low-risk hedge against inflation if I believe that Treasury Inflation Protected Securities (TIPS) aren't working?

I use an asset allocation strategy in my investment portfolio, and it calls for 15% in TIPS. The inflation premium for TIPS is based on the consumer price index, which is vastly understating inflation right now:

Bloomberg Article

The linked article suggests replacing TIPS with "derivatives tied to inflation expectations" and "corporate and agency bonds." I have no idea how to invest in derivatives, and corporate and agency bonds aren't low risk. It also isn't clear to me how they are an inflation hedge.

What do you think of those options? Are there any other options you would suggest?

posted by diogenes to work & money (6 comments total)

There are some inflation-protected mutual funds that invest primarily in inflation derivatives like FFGPX and others that blend derivatives with TIPS like SWRSX or PRIPX (there are many of these). Traditionally, real estate has been considered an inflation hedge, although that may not look so good to you at the moment. Similarly, commodities like gold have historically been seen as a hedge, but I really feel bad about them.

If there is a good way for individual investors to make small plays in the derivatives market directly, I don't know about it. I'd love to hear about it if someone smarter than I on the topic wanders along.

Personally, I'm still holding TIPS because I think the issue with the CPI is overstated. Energy prices will normally filter through the CPI market basket over time and the delta between the perceived inflation and the CPI will narrow over time. However, 15% seems like a very conservative allocation to me, particularly if you are holding them in a taxable account. My target is closer to 5%. Do you hold any other bonds or are TIPS 100% of your bond allocation?
posted by Lame_username at 7:37 AM on July 7

What does low-risk mean to you?

Agency bonds* have an implicit (or explicit in the the case of Ginnie Mae) US government guarantee. So if your appetite for risk is somewhere between US Treasuries and agency bonds, I don't think there's much out there.

*Aside from this ETF (MBB), I don't know how retail investors play directly in agency bonds. The traditional way is through the stock of agency REITs, but those are highly leveraged companies and clearly fall way outside your risk parameters. Agency bonds are an attractive trade right now, but I think it's a stretch to call them a hedge against inflation. I'm pretty sure the FTN recommendation was meant as a broader statement about asset allocation rather than as a strategy to hedge inflation.
posted by mullacc at 8:24 AM on July 7

Your best strategy would be turning off the investment porn and sticking to your investment plan. If you search for it, you will find all sorts of people willing to feed the conspiracy theories about the CPI, just as you will find lots of people who will feed the conspiracy theories about UFOs. You can choose not to buy into it.

The thing to keep in mind is that TIPS are intended to insure against unexpected inflation. Expected inflation is already built into the spread in interest rates between TIPS and regular treasury bonds. So if it is current inflation you are worried about, you would be just as well off with treasuries as TIPS. But TIPS will shine if inflation increases unexpectedly and are the best insurance against that event. There are many academic studies, as opposed to investment whores, who recommend as much as 50% of the fixed income portion of your portfolio be in TIPS.

Investing in something you don't understand is just performance chasing and likely will hurt your returns in the long run. TIPS are 100% guaranteed by the U.S. government. Derivatives are complicated, risky investments. Even the so-called experts have proven to have inadequate understanding of derivative risks as evidenced by the whole sub-prime meltdown. The basis for your strategy of having a portion of your portfolio in fixed income instruments is to lower risk. By going to derivatives you are substantially increasing risk and violating your plan. Stick to your plan.
posted by JackFlash at 8:35 AM on July 7

Thanks everybody. It looks like I'll be sticking with TIPS.

Here are the allocations I use. I've got them in a nontaxable account (Roth IRA)

The allocations are based on the book "Unconventional Success" by David Swensen.
posted by diogenes at 9:13 AM on July 7

Sounds like an excellent plan, diogenes. One of the best reasons for having a written plan is so that every time you feel tempted by something you see in Bloomberg or CNBC or Money magazine, you can look at your plan and reject it. It's like having an AA buddy you can call when you need him.
posted by JackFlash at 9:34 AM on July 7

Swenson's book is excellent. Although I would advocate a more aggressive allocation for most people, the more important concept is to have a plan and the discipline to stick with it. Good luck to you. You might look at the books by William Bernstein if you decide to do more reading. He is in the same vein as Swenson and quite thoughtful.
posted by Lame_username at 10:03 AM on July 7