CEFs for Inflation Protection

How can investors earn a reasonable rate of return, without putting the initial capital invested too much at risk? It's no secret that banks are offering record low interest rates on checking accounts, savings deposits, money market accounts, and certificates of deposit. Also, many investors are wary of locking in low rates for years if, as many market pundits believe, interest rates are set to rise. With the growing fear of upcoming rampant inflation, investors seeking a place to park cash for a short period of time find themselves in the midst of an investing conundrum.

One solution may be closed-end funds, or CEFs, that invest in short-term and inflation-protected government securities. To be sure, any investment can lose value. But the strategy of such CEFs includes capital protection; they aren't going to take big bets in the hope of capturing huge gains.

Both short-term bonds and inflation-protected investments have advantages. Although current rates are low, they can't fall below zero (on an absolute basis). This is the crux of the argument for many who believe that rising interest rates are inevitable. If this is true, short-term bonds have an advantage over longer-term (although typically higher-yielding) bonds: Because they mature more quickly, their prices are less sensitive to interest-rate movements. Investors in such bonds are not locked in long-term at currently low market rates.

During the last three years, many investors flocked to gold-related investments to protect against inflation (there are three CEFs investing in gold: Central Fund of Canada CEF, Sprott Physical Gold Trust Unit PHYS, and Central GoldTrust GTU), but such strong interest in the commodity has both pushed gold prices to record highs and premiums on gold-related CEFs higher. Although gold prices have risen at an enviable pace, the investment is not without risks and volatility. Admittedly, investing in a CEF with a portfolio of Treasury Inflation-Protected Securities is less sexy than gold, but these bonds offer protection against inflation with mush less volatility.PAGEBREAK

TIPS pay interest twice a year at a fixed rate based on the bond's principal amount, which adjusts for inflation (based on the movements of the Consumer Price Index, or CPI). If the CPI rises, the bond's principal amount increases, which creates higher semiannual payments. At maturity, bondholders are paid the higher of the original or adjusted principal amount.

There are six CEFs that invest primarily in government securities, though not all of them have large TIPS exposure. Most of these CEFs strive for income generation and capital preservation, though this is not foolproof: Witness the example of Federated Enhanced Treasury Income FTT below. Although these funds' distribution rates are generally lower than the CEF average of more than 6% at net asset value, their investments in government-backed bonds allowed the funds to better preserve capital during the 2008 market meltdown (the average CEF lost 27% of its NAV while this group's average loss was 8%). With the major exception of the above-mentioned Federated CEF, these funds' total NAV returns have been strong during the past one-, three-, and five-year periods, with little volatility.

Of these five CEFs, three are heavily invested in TIPS or other inflation-protected securities, making them suitable for investors seeking protection against inflation and rising interest rates. Investors may want to consider holding these investments in a tax-deferred account.

Western Asset/Claymore Inflation-Linked Opportunity & Income WIW typically invests at least 80% of its portfolio in inflation-linked securities. This is not a mandatory requirement, however, and the fund invests in a range of fixed-income securities, mostly investment-grade. Currently, close to 90% of the portfolio's assets are invested in U.S. Treasury Inflation-Protected Securities. The fund is currently unleveraged, but the managers use leverage tactically (when they view the market environment as favorable). The fund is selling at a 10% discount, which is larger than both its six-month and three-year average discounts of 8% each. During the past year, the fund's NAV has increased by more than 9%, and the fund's share price is up 6%. The fund pays a 2.9% distribution at NAV, which is typically from income. During fiscal 2009 and 2010, the fund paid a small portion of its distribution from return of capital.

Western Asset Inflation Management IMF invests in inflation-protected securities issued by U.S. and non-U.S. governments and corporations that are structured to provide protection against inflation. More than 90% of its assets are invested in TIPS. The fund uses a small amount of leverage from a reverse repurchase agreement. (The leverage shows in its slightly higher distribution rate than typically unleveraged WIW.) IMF's 3.2% distribution rate included return of capital during 2010, but its use was not destructive. Typically, the fund pays an income-only distribution. The current 7% discount is basically on par with the six-month average of 6% and the three-year average discount of 8%. During the past year, this fund's share price has increased by 10% while its NAV increased 9%.