Looking Beyond TIPS For Inflation Protection

By Aaron Levitt | November 01, 2010 AAA

As U.S. economy continues to struggle, another round of quantitative easing is being mulled over by the Federal Reserve. Policy makers are considering another round of debt purchases and analysts estimate that the Fed could purchase up to $2 trillion more in assets with the hope of stimulating the U.S. economy. This second major round of easing and other efforts to stimulate the stagnant economy have renewed many investors' worries about high inflation.

IN PICTURES: Eight Ways To Survive A Market Downturn

A Negative Yield
These inflation worries have come to a head with the recent auction of Treasury Inflation Protected Securities (TIPS). The Treasury Department sold $10 billion in five-year TIPS bonds this past Monday at a negative 0.55% yield. This is the first time the yield on maturity has been below zero. Bidders offered to pay $2.84 for each $1 of debt sold. Investors are willing to pay more and lose money in the short run, implying that inflation will be high enough to warrant the protection these bonds offer. Investments like the iShares Barclays TIPS Bond (NYSE:TIP) have become immensely popular with investors as a way to gain inflation protection. However, these bonds might not be the best all inclusive way to protect against inflation.

The main inflation gauge, the consumer price index and TIPS tend to have low correlations to each other. From 2002 to 2009, the correlation between the two was just 0.21% according to a recent article in the Wall Street Journal. This is troubling for an asset that is designed to protect against increases in the CPI. In addition, if inflation were to skyrocket very quickly, the fed could raise rates abruptly. In that scenario, TIPS bonds might beat standard Treasuries, but not many other asset classes.

A Variety of Protection Options
Overall, TIPS bonds still represent a good backbone for an inflation fighting portfolio, but they shouldn't be the only choice. There are a host of different asset classes that can be tapped to provide inflation protection. Here is a portfolio of options.

Having a 0.63 correlation to the CPI from 2002 to 2009, commodities make a good case as an inflation fighter. There are plenty of ways for investors to add a basket of commodities to a portfolio. For equities involved in the production of hard assets, the iShares S&P North America Natural Resources (NYSE:IGE) follows a basket of 130 different commodity based stocks with its highest concentration in oil and metals. These groups performed well during the inflation ravaged 1970's. The fund charges a cheap 0.48% in expenses and yields 1.06%. Similarly, the SPDR S&P Global Natural Resources (NYSE:GNR) offers a global play on this theme. The PowerShares DB Commodity Index (NYSE:DBC) follows a basket of various commodity futures contracts.

Another way to play rising inflation is through foreign currencies. As inflation devalues the greenback, investors will favor currencies from other nations who are keeping inflation in check. The PowerShares DB US Dollar Index Bearish (NYSE:UDN) makes a single easy bet that the dollar will fall. The Swiss franc, which is seen as a safe haven, can be accessed through the CurrencyShares Swiss Franc Trust (NYSE:FXF). Finally, combining the commodity theme with foreign currency, the WisdomTree Dreyfus Commodity Currency (NYSE:CCX) holds currency positions in nations such as Australia, Norway and Brazil, that will benefit from strong long term prices from their rich natural resource reserves.

Another great inflation fighter that many investors already own; large cap dividend stocks. From 1975 through 1980, when inflation was as high as 14.4%, large cap stocks gained nearly 38%, trouncing inflation. The most popular dividend option is the iShares Dow Jones Select Dividend Index (NYSE:DVY) which yields 3.67%.

Bottom Line
With another round of quantitative easing almost assured, inflation has returned to investors minds in a big way. The recent negative TIPS yield sold at auction proves how serious the potential problem is. However, there are plenty of other options for investors to fight inflation. Commodities, foreign currencies and dividend stocks are perfect tools for an inflation fighting portfolio. (To learn more, see Inflation Protected Securities - The Missing Link.)

Use the Investopedia Stock Simulator to trade the stocks mentioned in this stock analysis, risk free!

comments powered by Disqus
Related Analysis
  1. Is Canada’s Lagging Energy Sector A Good Bet?
    Stock Analysis

    Is Canada’s Lagging Energy Sector A Good Bet?

  2. India Remains An Emerging Market Bright Spot
    Stock Analysis

    India Remains An Emerging Market Bright Spot

  3. Still More Gains Ahead For Semiconductor Makers
    Stock Analysis

    Still More Gains Ahead For Semiconductor Makers

  4. Unconventional Drilling Still Has Room To Boom
    Stock Analysis

    Unconventional Drilling Still Has Room To Boom

  5. Finding An Alternative With Currency ETFs
    Stock Analysis

    Finding An Alternative With Currency ETFs

Trading Center