Fighting Inflation Beyond TIPS

By Aaron Levitt | June 28, 2012 AAA

Through their various quantitative easing and long-term refinancing operations, a variety of central banks and policy makers have injected tremendous amounts of liquidity into the markets. Many analysts and fund managers believe that these large liquidity infusions will ultimately lead to higher inflation and consumer prices down the road. With global growth slowing once again, the possibility of a third round of capital injections from a variety of nations is once again on the table. To that end, investors have flooded a relatively sleepy corner of the bond market with new capital and have driven yields to negative amounts.

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Huge Inflows
With the specter of inflation looming, U.S. bond buyers are increasingly willing to risk being repaid slightly less money than they have invested, as long as the bonds come with the benefit of inflation protection. Treasury Inflation Protected Securities, or TIPS, are bonds that provide a fixed coupon plus a rate adjusted with changes in the Consumer Price Index (CPI); investors have recently gone gaga over them. According to data from the ETF Industry Association, investors added $638 million to iShares Barclays TIPS Bond Fund (ARCA:TIP) in May.

That continued surging interest has helped push TIPS yields into negative territory. Currently, the yield on a standard 10-year Treasury note is right around 1.8%. However, the yield on a 10-year TIPS is yielding about -0.33%. Essentially, 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.

SEE: Curbing The Effects Of Inflation

Finding Protection Elsewhere
While TIPS bonds still represent a good backbone for an inflation fighting portfolio, the current negative yields and high break-even points are a little cause for concern. Overall, investors may be biting off more than they can chew in the sector. Luckily, there are a host of different asset classes that can be tapped to provide inflation protection. Here is a portfolio of options.

Basic materials like wheat, oil and nickel have traditionally been strong inflation fighters, as their prices tend to surge during bouts of inflation. During the last period of high inflation in the 1970s, both commodities and natural resource equities outperformed the general equities market. The PowerShares DB Commodity Index Tracking (ARCA:DBC) is still one of the best broad ways to play rising commodity prices. The fund tracks fourteen different commodities across the three major sub-groups of energy, agriculture and metals/mining. Expenses run a relatively cheap 0.93% and the ETF has managed to outperform the S&P 500 since its inception in 2006. Likewise, commodity producers like miner BHP Billiton (NYSE:BBL, BHP) and oil producer Exxon (NYSE:XOM) tend to outperform during periods of high inflation. The Market Vectors RVE Hard Assets Producers (ARCA:HAP) tracks 356 different commodity related firms.

One major issue for any bond investor, TIPS or otherwise, is that of rising rates; however, floating rate bonds adjust rates every 30 to 90 days, making them quite attractive in rising rate and inflationary environments. Both the iShares Floating Rate Note Fund (ARCA:FLOT) and SPDR Barclays Cap Investment Grade Floating Rate ETF (ARCA:FLRN) can be used to gain access to this overlooked asset class.

Finally, for investors looking for an "all-in-one" option for inflation fighting, both the IQ Real Return ETF (ARCA:CPI) and WisdomTree Global Real Return Fund (ARCA:RRF) could be compelling choices. Each fund takes a slightly different approach to inflation fighting. The CPI is an ETF of ETFs that attempts to overcome the problems associated with TIPS. Currently, the fund includes heavy weightings in the iShares Barclays Short Treasury Bond (ARCA:SHV) and the SPDR S&P 500 (ARCA:SPY). On the flip side, the WisdomTree fund is long on a hefty dose of international TIPS bonds with commodities, as well. The fund can also hedge its positions by going long or short; however, neither fund has really caught on with investors and have low trading volumes.

SEE: Introduction To Inflation Protected Securities

The Bottom Line
With the massive amounts of fiscal stimulus that have entered the markets in the last few years, inflationary pressures are mounting. Investors have flocked to funds like the PIMCO 1-5 Year US TIPS Index ETF (ARCA:STPZ) that bet on inflation-protected bonds. However, in light of these bonds' continued negative yields, investors may want to explore other options for inflation fighting. The previous funds are some examples of how to do just that.

At the time of writing, Aaron Levitt did not own shares in any of the companies mentioned in this article.

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