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Can TIPS Fully Mitigate Inflation?

Greg Brown

Greg Brown: Hi. I am Greg Brown, mutual fund analyst here at Morningstar. I am here today with Rob Arnott. Thanks for joining me today, Rob.

Robert Arnott: Thanks a lot.

Brown: In this time, you know, investors are very nervous about inflation, inflation in the near term and inflation coming up. And I am curious to know if – what you think about TIPS. Do TIPS – can they fully mitigate inflation? And is the CPI index a good indicator for inflation?

Arnott: The really short answer is no and no. The longer answer is TIPS, inflation-indexed government bonds are a very good way to hedge against inflation and are the natural asset of choice for a low-risk inflation hedge.

The problems with TIPS primarily center on the calculation of CPI. The government has a strong incentive to calculate CPI in a fashion that understates inflation. Why? Because it will have a bearing on the cost of servicing TIPS debt and much more importantly, on the cost of Social Security.

Brown: And how in your funds do you address the inflation concern?

Arnott: Taking a big picture portfolio view, most investors have the lion's share of their money in mainstream stocks and bonds. Mainstream bonds are brilliant in a disinflationary economic contraction. Mainstream stocks are brilliant in a disinflationary economic expansion. Both of them fall down in a reflationary environment.

So while most investors have two core portfolios, stocks and bonds diversified in whatever ways they chose. I think most investors need three. They need an allocation to equities to participate in economic growth. They need an allocation to bonds to tamp down the volatility and provide a reliable income stream.

And they need an allocation to a third bucket to protect against inflation and to gain diversifying exposure to alternative markets. That's missing in most investors' portfolios. It's non-existent for many, and it's small to middling allocation even for those who are avid adopters of the idea. So from an inflation perspective, our inflation toolkit is surprisingly broad.

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TIPS are a natural way to capture inflation. Commodities are seen as a natural way to capture inflation; they are not. They're natural way to hedge against inflation shocks. Expected inflation is baked into the forward prices on commodities. So you are already prepaying the expected inflation in the purchase of commodity futures, forward swaps. But you profit if inflation comes in higher than expected. So you are protecting against inflationary shocks.

The other obvious inflation hedges are investments in emerging market stocks and bonds, allocations away from the dollar. And investments in commodities and REITs. REITs represent an indirect allocation to real estate, which provides good, broad inflation hedging. And some lesser-known inflation hedges that are surprisingly powerful would be high-yield debt and floating income strategies. Both of these represent below-investment-grade investments, and so they have a yield spread.

And the yield spread is sometimes large because investors are worried about default. So, if you have renewed inflation, the real value of the debt is falling, the debt coverage ratios are improving, and the spread contracts; you wind up pocketing a rich yield and a capital gain associated with falling yields. So those represent back-doorways to allocate inflation protection. We use that full toolkit.