As investors have realized that equities are an imperfect shield from inflation, there has been growing demand for products designed especially to hedge this risk. The most popular is the U.S. government-issued TIPS—Treasury Inflation Protected Securities. But there are also new mutual fund, managed account, structured product and derivatives instruments on offer that may be of use to private investors.

Straight Tips
The government began issuing TIPS in 1997, and it is now a mature and easily accessible product. “This is a market that has grown pretty rapidly and has liquefied nicely—bid-ask spreads are now equal to the most liquid corporate bonds,” says George Oberhoffer, a senior practice consultant with Russell Investment Group, based in Tacoma, Wash. “Government-issued TIPS are far and away the most realistic option for a lot of investors.”

TIPS have a payoff that changes in line with the CPI for urban areas (CPI-U), published monthly by the Bureau of Labor Statistics. They perform well in a rising interest rate environment, but usually underperform other government bonds when inflation falls or is stagnant. Paul Greff, principal at State Street Global Advisors in Boston, explains that, despite the low level of inflation in recent years, it has been enough to boost the otherwise anemic performance of this instrument. “In the U.S., TIPS have probably been the single largest generator of excess returns over the last four years because we have seen real returns falling faster than nominal returns, which has given investors higher-price returns on TIPS,” he notes.

Just as with ordinary Treasury securities, TIPS pay a coupon that is a fixed percent of the principal amount. Unlike conventional bonds, however, the TIPS principal value is adjusted to reflect changes in the CPI-U. That means their price is very different from conventional Treasuries. If a typical 10-year bond had a yield of 4.25 percent, its inflation-linked counterpart might come with a stated yield of around 1.65 percent. Note, however, that the latter figure is a real (inflation-adjusted) yield, whereas the former is not. To get the real yield of the conventional bond, you have to deduct inflation from its (nominal) yield. If inflation turns out to be 2.5 percent over the life of both bonds, then the real yield on the nominal bond is actually just 1.75 percent, much closer to the inflation-protected security. If inflation in this example exceeds 2.6 percent, the TIPS will begin to outperform the conventional Treasury bonds.

As with a conventional bond, changes in the behavior of interest rates will also affect the relative performance of TIPS. “You’re exposing yourself to opportunity cost because if rates go up then you’ve locked yourself in at a lower rate,” Oberhoffer explains. “You’ve got a dilemma as you look at markets today because interest rates are still near pretty historic lows. If you lock in at 1.8 percent, then you’re going to be really annoyed if a year from now you could have gotten 2.5 percent.”

Because these instruments have a very low risk profile, portfolio managers suggest they be used as a foundation for a fixed-income portfolio. “Inflation-linked bonds are generally going to be among the lowest risk assets conceivable, so the less your risk appetite, the higher should be the concentration of TIPS,” Pimco’s Brynjolfsson notes.

Alternative Treatments
There are other methods of ensuring a real return on investments. One simple way is to invest in a real return mutual fund or managed account. Some of these invest in TIPS and other international inflation-linked government securities. (France and the United Kingdom are among the larger issuers of inflation-linked bonds.) Pimco, for example, manages a real return fund that is mostly invested in TIPS, but also includes other assets, such as high yield or emerging market bonds. The fund is discretionary rather than static, and as such it will not be exactly correlated with U.S. inflation. Instead, it is designed to protect against inflation while outperforming the market. To do so, it takes on more risk than a portfolio that simply invests in TIPS. Another type of mutual fund/ managed account invests in commodities or securities that track commodity prices, because these tend to rise in an inflationary environment. Real return funds typically charge a 3 to 4 percent sales charge; other fees vary.

Another tool for hedging inflation is a structured note with an inflation-linked payoff. For example, an investor can purchase an investment tied to the performance of the Dow Jones AIG commodity index, in which the initial investment principal is guaranteed (so the instrument would have very little risk). Index-linked products of this nature typically offer the investor some percentage of any positive move in the index. “We find that to be a particularly compelling approach at this stage because commodities and their associated indexes have had some big moves,” explains John Skjervem, the Chicago-based chief investment officer for Northern Trust’s personal financial services division. Products such as these typically have a five-year tenor.

Another promising source of hedging products is the emerging inflation derivatives market. These are very new instruments—most are only a few years old—and are now traded exclusively by sophisticated financial institutions. Oberhoffer expects the market to develop to the point where private investors can access it. But for now, the market for swaps on TIPS—a fairly straightforward derivative that allows investors to manage their interest rate exposures by trading fixed payments for floating, or vice versa—is still five years behind the regular TIPS market in terms of liquidity. “As these things become more liquid, I would think they should become a viable option for a high-net-worth investor looking to protect against inflation,” Oberhoffer adds.

If so, a private investor will someday be able to arrange a transaction in which he overlays a floating rate money market investment with an inflation swap that lets him pay the interest he receives from the money market and receive the total return on a TIPS bond for a certain period of time. The end result is a “synthetic” and less expensive investment in TIPS. Also, because a transaction like this needs to be only partially collateralized, it allows investors to leverage their principal, adding further flexibility, Oberhoffer notes.

Most believe inflation remains tame for the present. But the growing pressures in the housing and energy markets, along with the falling dollar and the fact that the Fed is hamstrung from raising rates too much by fears it will harm the economy, raise legitimate concerns about its reappearance. Private investors who worry about its caustic effects on a portfolio now have an array of tools to manage it, while earning a respectable return.

Tips Tax Trap
One significant downside to Treasury Inflation Protected Securities (TIPS) is their tax treatment. The investor’s overall income stream from TIPS consists of the coupon payments, made every six months, and the principal repayment at maturity. Both of these increase when inflation, measured by the CPI-U, rises. Unfortunately, the IRS takes an aggressive approach to taxing the gains. George Oberhoffer of Russell Investment Group explains: “The U.S. tax authorities tax the coupon payment that you receive and also the increase in principal value due to inflation, not when you receive it at maturity, but at the time that the principal amount is grown. So an increase in inflation actually has adverse tax consequences for a taxable investor.” Perversely, increases in inflation that should benefit the holder can actually cause him to suffer a negative return before maturity due to the need to pay tax.

Because of this, investment experts say that the best way to invest in TIPS is via a tax-deferred account. “If the investment is not held in a tax-deferred vehicle then you could have negative cash flows in the short term, because the taxes that you have to pay on the principal, which you don’t get back until maturity, are going to more than offset the coupons that you receive every six months,” says Bill Irving, a fixed-income portfolio manager at Fidelity Investments in Merrimack, N.H.

Nature of the Beast
Most investors can be forgiven for viewing the concept of hedging inflation as purely academic. After all, uncontrolled price rises have not been a problem since the 1980s. Many believe that policymakers have a handle on the issue. But history shows that inflation eventually rears its head after a long period of stable growth, as happened when the hyperinflation of the 1970s followed on the heels of a golden period of expansion in the 1960s.

John Brynjolfsson of Pimco says economic policymakers are often loath to address inflation in its earliest stages because doing so is almost always painful. It generally involves either raising interest rates—which hurts both stock and bond markets—or cutting government spending to take some of the wind out of the labor market. Neither is politically popular and can result in significant pressure on even nonpolitical, insulated entities such as central banks.
Another reason to doubt the government’s resolve, according to Paul Greff of State Street Global Advisors, is that the massive U.S. current account deficit now makes some degree of inflation attractive to policymakers because it lowers the real value of foreign (and domestic) claims on the country. Demographic trends that are inexorably leading to growing unfunded liabilities and a situation in which older consumers will outnumber younger producers might spur the government to allow inflation to run around 5 percent for an extended period of time, he adds.

So while the leading economies have been enjoying consistently low inflation for the past decade, there are pressures that may cause it to reemerge. Investors may want to take a proactive role in hedging themselves against the risk, rather than rely solely on the government to keep it in check. As Brynjolfsson says: “Fighting inflation is not everyone’s favorite thing.”

John Ferry is an Edinburgh, U.K.-based journalist who specializes in writing about financial markets and investments.