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“Inflation-Protected” Income Investing: Advice for Diversifying Beyond Conventional TIPS

Inflationary pressures picked up in the first half of the year, surprising establishment economists. Coffee and beef prices spiked. Crude oil jumped to over $110 per barrel. Prescription drug costs continued their merciless ascent higher. And even the government’s own rigged Consumer Price Index ticked up.

Consumer prices officially rose 0.4% in May, exceeding economists’ expectations. On an annualized basis, the CPI is rising at double the pace of last year. Mind you, official inflation is still mild by historic standards, but it won’t remain mild forever.

That’s why long-term bonds that are issued at today’s low, fixed rates are riskier than most people think. Bonds have been “safe” for the past 30 years, so it’s easy for the casual investor to assume that they are safe. They’re only as safe as the currency in which they are denominated.

These Bonds Are More Resilient to a Dollar Decline

If the dollar crashes, so will conventional, fixed-rate bond values. As an alternative to fixed-rate bonds, you can protect yourself somewhat against the risks of officially acknowledged inflation with Treasury Inflation Protected Securities (TIPS) and U.S. Series I Savings Bonds. They are adjusted for CPI, giving you the opportunity to keep up with the official rate of inflation in any given year.

We’ve had periods of double-digit inflation rates in the past and we undoubtedly will at some point in the future. If inflation rises to 10% a year and you earn 3.5% interest
on a regular bond, your real (inflation-adjusted) rate of return would actually be -6.5% — and that’s before you pay taxes on your nominal 3.5% “gain!”

With TIPS and I Bonds, you don’t have to worry about falling as far behind inflation as you could with fixed-rate bonds.

You can purchase I Bonds in denominations as little as $50 or as great as $10,000 (you are limited to a $30,000 total investment in I Bonds per year). Series I Bonds also have some tax advantages. They are exempt from state and local taxes, and federal income taxes are deferred until you redeem them.

The two big risks with inflation-adjusted bonds are:

  1. Your interest payments could be adjusted downward if the official inflation rate declines.
  2. The government can (and almost certainly will) manipulate the CPI figures so that they understate inflation.

A major drawback to I Bonds, and other types of Savings Bonds, is their lack of liquidity. You must hold on to I Bonds for a full year before you can get back any of your money (unless you have a government-approved hardship). In addition to the one-year minimum holding period, if you redeem I Bonds within five years, you’ll have to forfeit three months worth of interest. Series I Bonds currently sport a yield of 1.94% through October 31, 2014, after which yields will be adjusted based on CPI.

Inflation-Managed Funds
You Can Buy at a Discount

One way to get superior yields than those offered by the market – and therefore increase your odds of beating inflation over time – is by owning income-producing instruments through closed-end funds that sell at a discount.

There are a couple closed-end funds that focus specifically on inflation-adjusted securities. They currently sell at substantial discounts to net asset value (see table below).

The one that happens to be trading at the largest discount to its net assets is Western/Claymore Inflation- Linked Opportunities (WIW). The fund holds mainly U.S. Treasury Inflation Protected Securities. It also sports a 9.8% allocation to foreign bonds and 8.2% to corporates.

While this asset mix may not be the boldest or most exciting, it represents more diversification than you’ll get purely with dollar-denominated TIPS. Plus, the assets held are selling at bargain prices after taking into account the fund’s 12% discount.

Think Globally, Profit Locally

Inflation-adjusted bonds denominated in multiple currencies around the world offer higher yields and more potential ways in which you can beat inflation (i.e., currency appreciation and better inflation adjustments). Consider supplementing any investment in TIPS or I Bonds with SPDR International Inflation- Protected Bond (WIP) or PIMCO Global Advantage Inflation-Linked Bond (ILB).

For much broader diversification, consider PIMCO Inflation Response Multi-Asset D (PDRMX). This mutual fund is designed to give investors comprehensive exposure to inflation-resistant assets, including TIPS, emerging market currencies, commodities, gold, real estate investment trusts, and certain other debt and equity securities.

It also uses leverage, which is another strategy that can pay off during rising inflation – not so much when asset prices are on the decline. Expenses are likely to be a drag on the fund’s performance. PIMCO Inflation Response doesn’t trade at a discount and does carry a relatively steep expense ratio of 1.20% (double the 0.6% charged by PIMCO’s ILB ETF).

Assuming you own physical gold bullion directly and own stocks and other assets separately, you may do well to skip PDRMX. The concept is nice, but you can execute it better through other vehicles, including some of the ones mentioned in this article.