Jason Stipp: I'm Jason Stipp for Morningstar.
You may have noticed at the gas pump or in a grocery store that certain prices on certain items have risen recently. Naturally this leads to fears of oncoming inflation and also ways that you might hedge against inflation in your portfolio.
Here with me talk about some common inflation tools, their pros and cons, is Christine Benz. She is director of personal finance for Morningstar.
Thanks for joining me, Christine.
Christine Benz: Jason, great to be here.
Stipp: So, the first tool I think is the one that might to come to mind as the most obvious inflation protection, and that TIPS. And there are some important things to remember about how TIPS behave in order to use them effectively. What should you have in mind about TIPS if you're looking at them right now with some worries about inflation on the mind?
Benz: Well, you're right, they do have the most explicit inflation protection, so what happens with the TIPS bond is that you do get that bump up in your principal value as the CPI bumps up. So there is that explicit inflation hedge.
A couple of key things to keep in mind with TIPS right now is that they are pretty interest rate sensitive. We've not seen them stress-tested in a period of rising rates over many years, but what we have seen over short periods of time is a lot of interest rate sensitivity, not necessarily something you want, where the threat of rising rates looms large.
They are also a pretty tax-inefficient vehicle. So, to the extent that you hold them, you want to keep them within the confines of a tax-sheltered vehicle.
Stipp: So, I think it's an important distinction between the measure of inflation and the measure of interest rates, because they don't always move at the same time. We normally think, more inflation, higher interest rates, but you can see them move at different times, and that can cause some of the dislocation in what you might expect of TIPS performance?Read Full Transcript
Benz: Well that's the thing. And Jason, an important thing to note what TIPS is as with any asset class, they can get mispriced. So, investors can get a little ahead of themselves in terms of anticipating or over-anticipating inflation, and TIPS can get expensive, but they can also get cheap. So the best strategy if you are adding TIPS to your portfolio, since you don't really know, is to dollar-cost average in my view.
Stipp: Commodities is another area, and we are consumers have commodities. We are at the gas pump. We pay for them. It might come to mind that you might want to invest in commodities if their prices are going up. It could be a way to hedge against the outlay of extra cash that you have to make when you are purchasing commodities, and they factor into food and everything else.
What should I think if I wanted to go into commodities and try to use that as a hedge?
Benz: So the thesis behind these commodities investments, which have really taken off within say the past five years, is that you do get to participate in price increases in real stuff. The big thing to keep in mind is that a lot of the commodities vehicles, or really most of the exchange-traded funds and other vehicles on the market, they are using futures-based strategies, which don't always perfectly track the current prices of commodities.
And that phenomenon is called contango, what we have experienced recently, has meant that investors really haven't experience through their commodities funds what's really gone on with commodities prices. So, an imperfect measure there and also there is this issue of commodities as standalone investments--extraordinarily volatile--and what I have seen just kind of observing investor flows into some of these funds is that investors have kind of misused them.
So there was this big stampede into commodities prior to 2008, then they really plummeted during that period. A lot of investors left, gave up on the asset class. So to the extent that you hold them, keep them to a small size of your portfolio. This is certainly another asset class where I'd dollar-cost average in to avoid buying right before there is a big bust.
Stipp: Remember that there could be lots of ups and downs with them.
Stipp: Another thing that investors do think about is the rising rate environment. It's the worries about their fixed-income portfolio. There are some options for them, fixed-income instruments, that will also adjust as rates rise, that could be something they might want to consider.
Benz: So, I would point to bank loan funds here Jason, and this is some research that our colleagues at Morningstar Investment Services did, looking at the inflation characteristics of various categories of funds. What they saw was a lot of inflation resistance among bank loan funds, and the key reason is as you said, with fixed-rate investments when inflation goes up, you'll also tend to see interest rates go up, which will put downward pressure on the bond prices.
Floating rates, or bank loan funds, have an important mechanism in that the interest rates reset along with LIBOR. So you do have that imperviousness to interest rate rises, and you also tend to have some inflation protection as well.
Stipp: There is an important thing to keep in mind as well for these types of bonds that you had mentioned to me, and that has to do with the credit quality side of the house. What do you need to keep in mind about how safe those bonds as far as the payback that you would ultimately get?
Benz: Right so that is a key thing to keep in mind. We saw terrible performance from some of these bank loan funds--I mean, really stock-market-like losses from some of these funds. So you want to focus, in my view, on the ones that have the higher credit qualities. They will not deliver the greatest returns on the upside versus some of the junkier bank loan funds, but Fidelity's fund is one that our analysts like quite a bit. They think that that's a fund that has a good balance of exposure to the bank loan category, without a lot of credit risk.
Stipp: So, the last thing Christine that I wanted to talk about is stocks, and I think that there is some people who say stocks can be a really great hedge against inflation and others say, well it really kind of depends. How should I think about using stocks if I want to have an inflation hedge from equities?
Benz: Well one key benefit to stocks in an inflationary environment is that they will in aggregate tend to behave pretty well when the economy is going strong and that in turn tends to spur inflation. But stocks are really a blunt instrument for fighting inflation.
So there are lots of different categories of companies. Some will actually be quite susceptible to rising prices and perform poorly. So not every stock or stock fund will perform well, but they do have an important advantage in that you do have the opportunity to earn higher absolute returns then you can on most fixed-rate investments.
So, if you are thinking that long-term inflation is going to run around 3%, you do have the opportunity to earn rates of return higher than that, substantially higher than that. You also have the opportunity to have much larger losses. So, you need to keep that in mind as well.
Stipp: So, certainly if you need that longer-term earnings power, definitely you want to think about having some stocks, but make sure that you have a longer time horizon that you are not going to have to tap that asset class in the short term and that you have other safer assets you can tap into.
Stipp: Christine, thanks so much for your tips on inflation and the inflation-fighting investments.
Benz: Thank you, Jason.
Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.