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Make Your Bond Portfolio Inflation-Resistant

When prices rise, fixed-income investors have the means to withstand the threat.

Marta Norton, 08/30/2010

With stagnant home prices and unemployment near 10%, U.S. deflation has been harder to shake than many would have guessed. Yet, rock-bottom rates and massive stimulus give many investors, including us, reason to believe that inflation could pick up at some point down the road.

If and when we see signs that seem to augur rising prices--for example, stabilizing rents, rising average wages, higher capacity utilization--we will tactically adjust the portfolios that we manage in the name of managing total return and risk. We might shorten duration or overweight hard assets, to name a few possibilities.

But those adjustments aren't necessarily options for investors who depend on a fixed income, such as retiring baby boomers who will likely require more exposure to bonds in the years to come.

So, how does one create a bond portfolio that may mitigate the pressure of rapidly rising prices without taking on lots of risk? Drawing on our experience managing income-oriented portfolios for clients, we've prepared the following summary of useful vehicles that investors can incorporate into their fixed-income portfolios in an effort to combat inflation. To facilitate portfolio construction and illustrate how these various securities could be applied in practice, we've also drawn-up a hypothetical "inflation-fighter" bond portfolio.

(View the model portfolio here.)

Morningstar's director of personal finance, Christine Benz, recently conducted a video interview with Norton about this portfolio. Click below to view it:

TIPS, the Obvious Choice
Treasury Inflation-Protected Securities are the obvious inflation hedge. The federal government adjusts the bonds' principal twice a year to account for changes in the Consumer Price Index. In effect, an investor who holds TIPS to maturity locks in a real yield while gaining complete inflation protection. No other bond can match that.

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