Definition of Inflation Protected
Inflation protected refers to investments that provide a hedge against the rise in prices of goods and services over time. An inflation-protected portfolio, for example, will have assets that perform well in times of higher inflation. An inflation-protected investment will contain some type of adjustment mechanism that periodically ratchets the payouts up and down according to the rate of inflation.
Breaking Down Inflation Protected
Inflation-protected investments and portfolios are meant to guard the true value of a portfolio in terms of purchasing power. Inflation protected is similar to inflation hedged, with a slightly stronger emphasis on how reliable the asset or assets are in times of high inflation.
Treasury inflation-protected securities (TIPS) are engineered to be inflation protected. While the interest rate of these securities remains fixed, the par value of the security goes up with inflation in the Consumer Price Index. TIPS and other inflation-protected securities (IPS)—particularly those issued by other sovereign governments—are relatively low risk, which unfortunately means the real interest rate is lower than other bond options.
However, in times of high inflation, TIPS rise in terms of real value and provide a balance to other parts of a portfolio that can struggle in those economic conditions. Owing to how they are built, TIPS and other IPS have a far stronger track record of performing in periods of inflation than any other asset associated with inflation protection. TIPs and other IPS are also accessible through bond ETFs that carry a basket of TIPS or other issues.
Of course, if inflation isn’t significant over the lifetime of the IPS, then an investor is left with a sub-par investment for that duration. TIPS also come with some tax issues, as the coupon rate and any inflation adjustments trigger federal income taxes in the current year even though the adjustment to the principal isn’t realized until the investment matures or is sold.
Inflation Protection Through Commodities
Commodities and precious metals are often touted as protection against inflation with more potential upside than TIPS with their minimal interest rates. This is because commodities tend to appreciate during times of high inflation. This is generally true, but the reliability of commodities is not nearly as high as structured inflation-protected investments as they are also prone to regional and production risks. In fact, even the sensitivity of some of the most frequently used commodities for inflation protection can change over time. Some investors have opted for inflation protection by owning shares of commodity producers rather than dabbling directly in commodities.
The goal of any inflation protection is not to hedge 100% of the risk, but rather to diversify enough that the bite of inflation, while still painful, is not fatal to the portfolio’s value. A traditional bond and stock portfolio, for example, can be quickly chewed up in times of high inflation without TIPS or commodity-related investments to mitigate the damage.