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By Christine Benz | 01-31-2012 03:00 PM

Jacobson: Don't Forget About Inflation Risk

The Fed's commitment to keep rates low for years may have diminished interest-rate risk for Treasury investors, but inflation could still swallow up returns, says Morningstar's Eric Jacobson.

Christine Benz: Hi, I am Christine Benz for The Federal Reserve recently indicated that it would keep short-term interest rates down until 2014, causing bond investors everywhere to wonder what that would mean for their portfolios. Here to dig into that question is Eric Jacobson. He is director of fixed-income research with Morningstar.

Eric, thank you so much for joining me.

Eric Jacobson: I'm glad to be with you, Christine.

Benz: Well, I'd like to touch on this recent announcement from the Fed, Eric, and specifically address what it means for investors who are attempting to navigate this very difficult fixed-income environment. First of all, one group that has been particularly hard-hit by this very low-interest-rate policy has been people attempting to wring some sort of income stream from their very safe investments like certificates of deposit and money market funds. Does this mean that they really won't get any relief for the foreseeable future?

Jacobson: Unfortunately, I think that's probably the case. As you just said, traditionally people have been able to look to things like money markets and other short-term investments that are keyed off of these unfortunately very low Fed policy rates. So, I think you know the best thing for people to do at this point--something that we don't hear a lot about from the fund industry but makes a lot of sense--is to keep your eyes open for things like CD rates and other safe alternatives.

The one thing that you can say is that a lot of the banks in the industry have been looking for bigger deposit bases during the last couple of years, following some of the fallout from the trouble that we had in 2008. And banks that are seeking to have a more stable deposit base often are willing to offer a little bit more on CD rates. So, something that you may not have done before, if you've been dedicated to money market funds for example, might be worth a look.

Benz: So, online banks, for example, sometimes have very competitive CD rates?

Jacobson: That's right. Just again keeping in mind that certainly with the online stuff that you are dealing with the legitimate bank. Comparing to money markets, you are not necessarily talking about FDIC guarantees. But with banking certainly you want to be careful.

Benz: Right. So do your homework. Now, I'd like to address the other end of this spectrum. I think folks might look at this announcement from the Fed and say, "Well, if the Fed is going to have this benign interest-rate policy, why don't I take my fixed-income portfolio and just take it really long because presumably I may not get hurt with such a strategy." What do you say to people who might espouse such an approach given the Fed's policy?

Jacobson: I think you have to be very careful about making too big a bet doing something like going very long because I think that what you will find is that most managers think that in the near term it speaks to where we are with growth and inflation. But the fact that the Fed is planning on keeping rates very low for that long a time and the fact that there's at least the possibility, there is some debate certainly, but at least a possibility that the Fed may use additional measures to try and further stimulate the economy as we discussed offline--there is a little bit of a debate between different managers about whether or not we're going to have a third round of quantitative easing--that can spur inflation.

And if it does, it's the longer-term securities that are probably going to be hurt the first and the worst. So, what you are finding is managers are trying to sort of balance that by taking into account what it means to have low Fed policy rates at the front-end of the curve and at the same time the risk that longer-term securities could be vulnerable if we have a spike up in inflation.

Benz: So you are saying just because the Fed is saying it's going to keep rates low, it doesn't mean that you would be completely impervious if inflation jumped up? You could actually get hurt by maintaining a longer-duration portfolio?

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