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MAKING CENTS OUT OF THE NEWS
Blog #37
(November 10th, 2011)
When Inflation’s Not an “If” – a Lesson from the Arkansas Traveler
By Tom McAllister, CFP®
It’s only a matter of “when," not “if.” Just as soon as inflation again rears its ugly head, it is sure to trigger an end to the thirty one-year bull market in bonds. When yields drop, the price of bonds goes up as a consequence, and that is what we’ve been experiencing in recent decades. With 30-year bonds currently yielding a mere 3% and medium term bonds less than 2%, we’re approaching the limit to which rates can fall.
It makes no sense to buy fixed income bonds, bond indexes or bond mutual funds these days. All are slated for declines when inflation takes off. In fact, longer term bonds should probably be sold, and soon.
Falling rates can be a good thing, of course. For example, if your credit rating allows, now is a wonderful time to take on a residential mortgage at less than 4%. However, the majority of my readers are no longer interested in new mortgages, since most have little or no mortgage debt outstanding. So how can you benefit from low rates and yet protect yourself when rates begin to rise?
There are a number of strategies which seek to provide inflation protection through a mix of asset classes with high correlation to inflation.
1. For the average investor, the simplest and probably the best solution may be found in Treasury Inflation Protected Securities (TIPS). These are $100 bonds issued by the United States government in five, ten, and thirty year maturities. They provide a modest interest rate with additional semi-annual adjustments to the principal value equal to the rise or decline in the Consumer Price Index. (This adjustment is taxable as it occurs). One significant disadvantage to TIPS: no adjustments are distributed until maturity. Since the tax on the adjustments can easily exceed any cash interest received, TIPS are most appropriate for IRAs and other tax-free accounts. TIPS may be bought directly from the government, and there are also TIPS mutual funds and ETFs available.
2. Another inflation-protection strategy involves precious metals - gold, silver, collectible coins, and platinum. All of these tend to reflect inflation directly. Unfortunately, not only do precious metal investments involve security, storage and insurance costs, they generate no cash flow. High markups are common, as are volatile price swings. In fact, current prices of precious metals already appear to reflect inflation expectations.
3. Other commodities can be traded in the futures market and these tend to increase in price to reflect inflation. Commodity investing involves leverage and extreme volatility, which explains why 95% of individuals who invest in commodities lose money!
4. One investment option is notes whose interest is linked to changes in commodity prices. usually featuring lower issuer credit quality. “Floating Rate” notes, issued by companies with less than investment grade credit carry the same risk of default.. Neither of these choices is appropriate for average individual investors.
5. The “safest” course of action may well be fixed income investments with maturities of less than two or three years. With yields less than one percent on such investments, investor losses are assured when inflation is considered.
6. The truest inflation protection may not involve fixed income investments at all, but rather high quality, dividend-paying common stocks. Historically, price gains and dividend yields combined have tended to outpace inflation.
Remember “The Arkansas Traveler”? A traveler sees the old man fiddling away with a rooftop leaking like a waterfall.
You'd better mend your roof," said he.
But the old man said as he played away, "I couldn't mend it now, it's a rainy day."
The traveler replied, "That's all quite true, But this, I think, is the thing to do;
Get busy on a day that is fair and bright, Then patch the old roof till it's good and tight."
But the old man kept on a-playing at his reel, And tapped the ground with his leathery heel.
"Get along," said he, "for you give me a pain; My cabin never leaks when it doesn't rain."
The time to weather-proof your portfolio is before inflation sets in, replacing the bonds and other fixed-dollar investments with those than can grow, not shrink, with inflation!
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