The Federal Reserve is closely watching several key economic indicators right now to see whether inflation will rear its head any time soon. And if inflation does appear, the Fed has shown signs that it will raise rates slowly in an effort to stave off market volatility. But the job market may continue to improve, and prices may keep rising, which means that bond prices will drop as investors begin to seek protection from inflation. Here are five things that you can do to hedge your bets if inflation does reappear on the horizon.
- Reallocate money into stocks: If inflation returns, it could be a shot in the arm for the stock market while bonds could suffer. Consider reallocating 10% of your portfolio from bonds to stocks in order to take advantage of this possible trend. Buying preferred stocks is another possibility. These liquid issues will pay a higher yield than most types of bonds and may not decline in price as much as bonds when inflation appears. Utility stocks represent a third alternative, where the price of the stock will rise and fall in somewhat predictable fashion through the economic cycle and also pay steady dividends. (For more, see: A Primer on Preferred Stocks.)
- Diversify internationally: There are several major economies in the world that do not rise and fall in tandem with the U.S. market indices, such as Italy, Australia, and South Korea. Adding stocks from these or other similar countries can help to hedge your portfolio against domestic economic cycles. Bonds from foreign issuers can likewise provide investors with exposure to fixed income that may not drop in price if inflation appears on the home front.
- Look to REITs: Real estate investment trusts (REITs) carry holdings in commercial, residential and industrial real estate and often pay higher yields than bonds. One key advantage that they offer is that their prices probably won’t be as affected when rates start to rise, because their operating costs are going to remain largely unchanged. The Vanguard Global Ex-U.S. Real Estate Index (VNQI) is an excellent exchange-traded fund (ETF) that can get you broad-based exposure in this area.
- Look to TIPS: Treasury inflation-protected securities (TIPS) are designed to increase in value in order to keep pace with inflation. The bonds are linked to the Consumer Price Index and their principal amount is reset according to changes in this index. TIPS have dropped in value in the secondary market by about 10% over the past couple of years. They may be a good bargain at this point, as they have not yet priced in the possibility of inflation. These instruments are not going to provide you with stellar returns, but they could outperform Treasuries if inflation does appear. However, they are complex instruments, and novice investors may be wise to buy them through a mutual fund or ETF. (For more, see: Hedge Your Bets With Inflation-Linked Bonds.)
- Look to senior secured loans: Senior secured bank loans are another good way to earn higher yields while protecting yourself from a price drop if rates start to rise. The prices of these instruments will also rise with rates, as the value of the loans increases when rates start to rise (although there may be a substantial time lag for this). The Lord Abbett Floating Rate Fund (LFRAX) is one good choice for those who seek exposure in this area.
The Bottom Line
These are just some of the ways that you can start to hedge your portfolio against inflation. (For more, see: Should You Worry About the U.S Inflation Rate?)