Jonathan E. Lewis
01/01/2006
The bond manager walked away from his desk and onto the darkened trading floor. He left behind a yellow pad and these words: “It was the best bond portfolio, and the worst bond portfolio. It preserved principal, but it lost purchasing power. It generated income, but lost ground to inflation. It was a wealth preservation strategy, but not a lifestyle preservation strategy.” These are the first sentences of a book yet to be written, A Tale of Two Bond Portfolios. Will it be a tragedy, or a triumph?
If the two brothers in our novel want to protect their purchasing power, they must have a correct understanding of the inflation risks they face. For many investors, understanding inflation means knowing about the Consumer Price Index, a national average. Today, CPI is running at about 3.6 percent. But CPI is not the best measure of inflation for our two brothers—and it may be the wrong measure of inflation for other investors, as well.
To illustrate this point, let’s assume our two brothers live in Chicago and New York (we could have chosen Idaho and North Carolina, but this is a novel). They want to run for political office, and they need to protect their inheritance from inflation so they can pay for future campaigns. The Bureau of Labor Statistics, which calculates the national CPI, also calculates a CPI for the regions where our brothers reside: The Chicago inflation rate is 2.9 percent; New York’s is 4.1 percent. If our brothers want to maintain their purchasing power, they need to earn a higher yield on their bond investments than the level of inflation they experience. If they earn a yield lower than the level of inflation they experience, our brothers will fail to keep up with inflation, and as a result they will lose purchasing power (and maybe their future elections).
For our brothers, purchasing power protection using standard municipal bonds inevitably leads to region-specific yield curve strategies. For simplicity, let’s assume the brothers are only concerned with maintaining purchasing power relative to today’s level of inflation. Our Chicago brother can accomplish this goal by purchasing a two-year municipal yielding 3 percent. For our New York brother, the 3 percent yield on a two-year municipal will fall short of his inflation rate. He can only match his inflation rate by purchasing bonds yielding about 4.1 percent in the 10-year maturity range.
Novel Approaches
Real return strategies have the benefit of focusing our
efforts on our most important objective: maintaining purchasing power. Yet, if
they are applied in a single-minded fashion, there may be unintended
consequences. Our New York brother is in a difficult situation. If he wants to
preserve his purchasing power, he needs to buy 10-year bonds. Yet, those very
same bonds are sensitive to interest rate risk and can experience a sharp drop
in price if interest rates rise suddenly. In other words, the best portfolio for
maximizing real rates (yield minus inflation) may be the worst portfolio for
preserving capital—and a campaign war chest—in a rising rate
environment.
Active management portfolio strategies that balance inflation,
interest rate and credit risks are the only viable solution to the challenge
faced by our New York brother. Municipals, a long-term store of tax-efficient
purchasing power, can be a part of this solution when managed properly (passive,
laddered strategies are likely to fail in this environment). Inflation-linked
municipal bonds (muni CPIs) and U.S. Treasury inflation-protected securities
(TIPS) both have their drawbacks, but when used in modest measure (and in the
proper tax shelter for TIPS) they can contribute to a balanced, tax-efficient
real return strategy. For investors willing to consider international fixed
income investments, foreign currency–denominated inflation-linked securities may
also be able to play a role.
By combining various fixed-income securities in
a customized fashion, both our Chicago and New York brothers can have bond
portfolios that generate positive real returns over the longer term, preserve
purchasing power and keep their electoral hopes alive. If they are willing to
hedge their inflation risk with inflation derivatives, so much the better—as
long as these derivative instruments are used methodically within a robust risk
management framework. The end result of these efforts is an inflation-protected
portfolio. Tragedy will be averted, and our novel can end in triumph.
 | Jonathan E. Lewis is a founding principal of New York–based Samson Capital
Advisors. |