Inflation is of course a topic on everyone's mind, especially those in retirement or living on the proverbial fixed income. Unfortunately the most common way to get inflation protected income, which are TIPS or Treasury Inflation Protected Securities, basically Treasury bonds that are indexed at the rate of inflation, they are not giving you a whole lot in the way of income--though it is fixed--under 1% right now.
But what's interesting is, if you ferret around a little bit there are other ways to get a real income stream, that is, an income stream that should rise with inflation, and gives you some protection against inflation.
I think one of the best examples of that phenomenon is a company called Magellan Midstream Partners. This company's inflation protection, inflation hedge characteristics, are rooted in the way that its pipelines are regulated. It literally receives increases in the prices that it can charge shippers for fine petroleum products through its pipelines that are indexed directly to the Producer Price Index.
If they then turn around and invest that money in a project, like a new tank farm, that provides a 10% or 15% return on the capital invested, now the profits have grown for everybody. Everybody gets that much more of an increase. We're actually looking for 7% annualized per unit distribution growth for Magellan over the next couple of years.
Peters: This really gets down to understanding how utilities are regulated, which, even though they are very simple businesses in theory, you have to understand how the basics work. Essentially, it's almost like a savings account. Shareholders put a certain amount of money into the utility, which then goes out and it builds utility networks, power plants, power grids, power meters, the whole works.
How much they are able to charge customers is essentially how: much is the cost to operate that system, the line trucks, and the coal or the natural gas or whatever, and then what kind of allowed return do investors have? Typically its 9% to 11% return on equity that they're allowed to earn.
The way U.S. utilities are regulated is that that number tends to be sticky. If inflation in interest rates drop, allowed ROEs tend not to drop as fast. But if inflation and interest rates start to move up, chances are that those allowed returns are not going to go up as fast.
Dorsey: Making them not a very good inflation hedge...
Peters: Making them not terribly good inflation hedges, which is not to say that they are pure bonds, because most utilities do have still some growth potential, but they're going to be slower to reprice, kind of a like a portfolio of very long-term bonds compared to a portfolio of shorter-term bonds.
Dorsey: But I'm assuming we're going with this is that the U.K. utilities are regulated differently.
Peters: Yes. In the U.K. National Grid is regulated on a real return basis. It actually has a real return on equity requirement, and inflation, which is measured for U.K. consumers, is actually tacked on to customer's bills by an index formula, just like Magellan's.
Now you might think it's a little bit strange as U.S. investor to hedge yourself against inflation in the U.K., but….
Dorsey: No, I would never think that Josh...
Peters: ...But actually there is a logic to it, even from the standpoint of a U.S. investor. If there is a differential in inflation, inflation is say much higher in the U.K. than it is here, chances are that its currency will drop, and that in turn would hurt the value of your dividends here, but that's just the first order of fact.
If inflation is much higher in the U.K., then those customer bill increases and the nominal dividend increases that National Grid can provide will go up that much faster. In the long run, they you should be correlated such that you actually do earn the real return from National Grid, and that the inflation adjustments and currency adjustments will tend to cancel out.
Dorsey: So for National Grid, it's a C-corp, simple company that doesn't have the MLP tax complications.
Peters: Yeah, it's actually an ADR, but that's a qualified dividend payer OK for IRAs.
Dorsey: OK for IRAs. You know it does have some of these complications with regard to the U.K. inflation indexation. It should work out fine over time, and of course U.K. dividends don't have any automatic withholding as many foreign dividends do.
There's a third stock we're talking about, Health Care REIT, that doesn't have any of these complications. It's a U.S. company, not an MLP, and has about a 6% yield, indexed to inflation or largely index, anyways.
Peters: It's indexed up to a point. I mean, one of the great things about Magellan and National Grid is you've got these regulatory frameworks that provide virtually automatic pass-throughs. It doesn't mean that inflation might not get out of control and then the regulators rethink it, or that something else could happen to the business; it's not guaranteed. But they're much better long-term hedges.
Now to the extent that those are more complicated or may be more expensive, or otherwise not available, you tend not to think of a long-term portfolio of commercial real estate leases as something that could help you cope with inflation, but Health Care REIT actually I think would do a pretty good job of having its dividend keep up with inflation, up into the mid-single digits.
Dorsey: And just to take a step back, do you want to let people know what Health Care REIT does, what types of assets they own?
Peters: It's actually a very simple business. What they do is essentially finance nursing homes, skilled nursing facilities, medical office buildings, pretty much anything other than directly owning hospitals would be part of their purview.
What they do is that they own the real estate and then they lease it back to the operators of those facilities under what are called triple net leases, where literally the tenant has to pay for the maintenance, the property taxes, the insurance--that's the triple part--and it's locked in over a very long period of time.
Now if these were literally bonds, and they were totally fixed, you would say, there is no difference here between this risk and owning long-term Treasury bond. In fact, these leases are built-in with adjustments that are driven by inflation, up to a certain point, up to 2%, 2.5%, 3% a year, that inflation was automatically passed on to the tenants, which in turn means Health Care REIT has more money with which to fund dividends to shareholders. And based on the company's past practices, it almost certainly would match higher inflation with higher dividends up to the level that it would be able to.
Dorsey: So, essentially you think of Health Care REIT as a TIP yielding 6% that will hedge you against inflation up through the mid-single digits. If we got inflation much higher than say 5% or so, that hedge would not work as well.
Peters: Yeah, there is always a certain danger in comparing any stock to any bond.
Dorsey: Right, again, you're not principal protected on owning Health Care REIT, and the inflation protection is…
Peters: It's imperfect, it's a hedge.
Dorsey: It's in the contracts, but it's not one for one, the way a TIP is.
On the other hand 6% versus 1% buys me a lot of insurance premium.
Peters: That does, and I think that's exactly the right way to think about it. To think in terms of total return, which is the yield that you're getting plus the growth potential, which hopefully results in capital appreciation over the long run, but then to back out some assumptions about inflation, and to think in terms of, inflation is going up, can my dividend go up a little bit faster and preserve that yield as my total return.
The way we look at Health Care REIT is that even if inflation stays relatively low over the next couple of years, we are looking at 4%-5% potential dividend growth, which I think makes for a very attractive total return on top of that 6% yield.
If inflation moves into the mid-single digits, then we could start looking at mid- to high-single digit dividend increases from Health Care REIT. Maybe the total return comes down a little bit after adjusting for inflation, but I can still take that whole dividend yield and put it in my pocket and let the company essentially take care of keeping me current with inflation.
Dorsey: Sounds like a pretty good deal. Better than a TIP.
Peters: I'd have to agree.
Dorsey: With that, we'll close things. Thanks so much for joining me. I'm Pat Dorsey.
