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By Pat Dorsey, CFA | 12-02-2010 07:12 PM

Three Inflation-Fighting Alternatives to TIPS

Morningstar's Pat Dorsey and Josh Peters discuss three investments that offer a hedge against inflation while also providing better current income than Treasury Inflation-Protected Securities.

Pat Dorsey: Hi. I'm Pat Dorsey, director equity research at Morningstar.

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'm happy to be joined by Josh Peters, my colleague, who runs Morningstar's DividendInvestor newsletter and is an expert on not just inflation but income streams. Thanks for joining me Josh.

Josh Peters: Thanks Pat. Good to be here.

Dorsey: So, we've talk about MLPs in the past, a group securities that typically own pipelines. There are some tax complications, maybe not something you want to own in an IRA, but they do offer very nice inflation protection.

Peters: Yes, in fact these are the kind of securities that even once they get to full, fair value type of price, maybe even a little bit beyond, I think they are worth continuing to hold for that kind of protection.

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.

Dorsey: The PPI usually runs a little ahead of the CPI, which is even better...

Peters: Because it's more heavy into commodities. For example, consumer price inflation this year, CPI inflation, is practically nonexistent. The PPI is actually up a couple of percentage points. On top of that, if you can believe this, the companies that operate liquids pipelines are able to get a premium to that. There is actually an extra 130 basis points, 1.3 percentage points, that they are allowed to raise their rates in addition to that PPI adjustment.

Dorsey: So, essentially for Magellan, ticker is MMP I think, you are getting low 5%-ish yield right now on a fairly valued security and an income stream that is going to grow with inflation plus a little bit extra.

Peters: On top of that extra it even gets a little bit better.

Dorsey: There is a cherry on top.

Peters: There is a cherry on top. In addition to that inflation indexing in their revenue structure that should pass through inflation and a little extra, the company has been able to continue adding to its pipeline network with storage facilities and additional pipeline connections. When they do these things they typically issue new units. They had a yield of 5.5% or 6%.

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.

Dorsey: And then for investors who, maybe they have most of their investments in an IRA, so the tax complications for MLPs really kind of rule them out, we were talking about National Grid, which is a U.K. based utility that actually had some inflation hedging characteristics as well.

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