Is It Too Late to Add Inflation Protection to Your Portfolio?

High inflation readings are hurting consumers, and they have also sent investors scrambling to ensure that their portfolios are protected against the ravages of higher costs.

Investments that pay a fixed interest rate, such as CDs and bonds, are the most vulnerable to inflation, because it erodes the purchasing power of the yields that they pay out. And as we’ve seen so far this year, higher interest rates often follow from higher inflation, so bond investors have faced a one-two punch of declining bond prices and high inflation that eats away at the purchasing power of their income streams.

Other investment types, meanwhile, are relatively better situated to hold up in the face of inflation. Those investments cluster in three broad groups: those that offer a direct inflation adjustment as part of their returns (TIPS, I Bonds); those that have tended to generate higher returns in inflationary environments but don’t explicitly deliver a component of their return that is linked to inflation (commodities and commodities-related equities, REITs); and investments whose longer-run returns have tended to beat inflation over long periods of time (stocks).

Ideally, investors would maintain inflation protection on an ongoing, strategic basis, rather than attempting to add it after inflation has already reared its head and boosted the prices of inflation protection in the process. Dollar-cost averaging into a desired position size over a period of years helps alleviate the risk at buying in at a high point.

But what about investors who don’t already have such exposure in their portfolios? Is it too late to add it now in an effort to protect against future price increases? The timing question is an important one. After all, inflation is a risk that is likely to take a single-digit percentage bite of returns each year. But if the investor pays an inflated price for securities to hedge against that risk, those short-term losses can negate the value of future inflation protection. That was the experience of many investors who purchased commodities-tracking funds in the mid-2000s: Assets surged into these funds only to see commodities prices drop sharply during the global financial crisis as inflation fears cooled. Many newly arrived investors never recouped those early losses, never mind benefited from inflation protection.

Do new investors in inflation-protective investments face a similar fate? Let’s take a closer look at some of the key asset types that are associated with inflation protection and assess, the extent to which it’s possible, whether new investors are likely to be late to the party.

Treasury Inflation-Protected Securities and I Bonds

Treasury Inflation-Protected Securities and I Bonds offer the most direct inflation hedging of any investment type. Both offer an interest rate as well as an added return to help the value of their investors’ accounts keep pace with the Consumer Price Index for All Urban Consumers (called the CPI-U). If inflation, as measured by CPI-U, goes up, the owner of a TIPS receives an increase in his/her principal value. If inflation goes down, the principal value goes down, too. The interest paid on the bond is also indirectly affected by these changes to the principal value. Upon maturity, TIPS owners receive their original principal or the inflation-adjusted principal, whichever is greater.

I Bonds work similarly. In addition to a fixed rate of return set when the bonds are purchased, I-Bond holders also receive semiannual adjustments to their interest levels based on changes to CPI-U. A crucial difference is that TIPS holders receive semiannual interest payments, whereas I-Bond holders receive their accrued interest when their bond matures or they redeem it. I Bonds offer tax deferral because of that feature; the income isn’t taxed until the bond is redeemed.

For would-be buyers of I Bonds, it’s a mistake to overthink the timing question. Purchase constraints will limit the amount that you can sink into them in a given year—$10,000 per individual per year, plus an additional $5,000 that you can purchase with your tax refund. That effectively necessitates a dollar-cost averaging plan over a period of years if you aim to build a decent bulwark against inflation with I Bonds. Moreover, you won’t lose money if you buy and hold I Bonds to maturity, and regular inflation adjustments help ensure that your payments are a decent reflection of the current inflation rate.

The timing question for TIPS is a bit more complicated. Ultimately, whether TIPS are trading cheaply or dearly depends on how well the inflation expectations embedded in TIPS' prices reflect future inflation. To make that assessment, investors often look to what's called the 'breakeven rate" on TIPS—the difference between real yields on TIPS and the nominal yields on Treasuries. That breakeven rate is often used as a proxy for what market participants are expecting inflation to be over that specific time horizon. Right now, for example, the breakeven rate on five-year TIPS is about 2.7%; the 10-year breakeven is an even lower 2.4%. If inflation turns out to be higher than those breakeven rates suggest it will be, TIPS buyers will win because they'll receive inflation adjustments on their principal. That, in turn, will translate into a larger dollar payment at maturity as well as higher real yields as they receive coupons during the lifetime of the bond. If inflation runs lower than the breakeven rate currently, investors will have effectively overpaid for inflation protection.

It's worth noting that breakeven rates have tended to diverge significantly from actual inflation, however. At times in the past they’ve overrated the threat of inflation, and more recently, they’ve tended to underrate the inflation rate and its persistence. The fact that investors collectively have had a difficult time forecasting inflation, and in turn the attractiveness of TIPS, calls for humility with TIPS timing. In other words, a dollar-cost averaging plan is a good idea here. That said, the fact that breakeven rates are currently fairly low and have dropped substantially over the past four months suggests that new TIPS buyers—or buyers of TIPS funds—have a decent margin of safety built in at current TIPS prices. Of course, it's also worth noting that TIPS respond to other forces, especially interest-rate changes. That's why I prefer short-term TIPS funds like Vanguard Short-Term Inflation-Protected Securities VTIP over intermediate-term funds, which are much more rate-sensitive.

Commodities

Commodities-tracking investments aim to reflect price changes in items like basic materials, energy products, and agricultural products, which in turn the affect the prices we pay for a lot of our basic needs. Such investments have delivered in this year’s inflationary spike: The typical broad basket commodities-tracking fund has gained 15% on average. In other words, their returns have nicely offset inflation and then some. (A separate issue: Commodities funds typically obtain exposure to commodities prices via futures, which for technical reasons have tended to be an imperfect reflection of commodities prices.)

Commodities-tracking investments tend to be much more volatile than TIPS and I Bonds, though. Moreover, commodities' value will be driven entirely by demand for them and future levels of inflation, both of which are extremely hard to predict. If inflation continues to run high, commodities prices could continue to escalate. But if recessionary worries pick up steam, commodities prices could drop in a hurry, harming new buyers. Indeed, commodities prices have been trending downward over the past month and a half as recessionary chatter has come to the fore, with the typical commodities-tracking fund down about 11% over the past three months. Owing to those boom-and-(mostly) bust cycles and the fact that inflation and commodities demand had until recently been slack for a decade-plus, the 15-year average return on commodities funds is in the red.

In short, a call on whether commodities-tracking investments are trading cheaply or dearly comes down to a call on the health of the economy and the future rate of inflation—in other words, something that can only be glimpsed through a crystal ball. As with TIPS, commodity prices seem to be reflecting an expectation that economic growth is likely to taper off, which provides new buyers with a small margin of safety that they wouldn’t have had a few months ago. Investors who want to employ commodities-tracking exposure—even more than with TIPS—should go in with a dollar-cost averaging plan and a long-term mindset, because the timing risk is still very high.

Commodities-Related Stocks

While commodities-futures-tracking investments provide more direct exposure to price changes in oil and gas, metals, agricultural products, and the like, companies that produce and distribute these products tend to benefit during inflationary cycles, too. Stocks of energy companies, for example, have soared more than 50% over the past year, by far the best-performing major equity sector.

Additionally, commodities-related stocks have an advantage over pure commodities-tracking investments (that is, commodities futures funds) from the standpoint of timing decisions. Because these companies produce cash flows, it's possible to come up with an assessment of what they should be worth at any given point in time. Based on Morningstar analysts' bottom-up research, energy stocks in our coverage universe are now trading at a roughly 4% discount to their fair values. That means that their price/fair values are substantially higher than the broad equity coverage universe, however, which is trading at a roughly 20% discount to fair value. Other commodity-related stock sectors have relatively more attractive median price/fair values. For example, stocks in the mining and basic materials sectors are currently trading at a roughly 20% discount to fair value, according to Morningstar Direct. But that's no better than the price/fair value for the broad market, and such stocks often entail substantial volatility and cyclicality.

Real Estate Investment Trusts

Real estate investment trusts have historically fared reasonably well as inflation hedges. That's because the owners of the apartment and office buildings, shopping malls, and hotels in REIT portfolios are often pushing through rent increases, which in turn enhances REIT payouts and security prices, at times when inflation is running up. This year has been a different story, however: REIT indexes have dropped about 19% for the year to date, even more than the broad U.S. market. Rising interest rates explain much of the downward pressure on REIT prices: Not only do higher short-term rates cut into REITs' profitability, but higher bond yields also diminish REITs' desirability for income seekers. That continues a broader trend of REITs more closely tracking the broad U.S. equity market: As we noted in our research report on diversification and correlations earlier this year, REITs' correlations with the rest of the U.S. market have trended up significantly over the past few decades.

If investors still want to go ahead and add REITs for inflation protection, however, they appear to have a decent margin of safety to do so. The typical REIT in Morningstar's equity analysts' coverage universe was recently trading at a 10% discount to fair value. However, that's a bit less of a discount to fair value than the total global coverage universe, which is trading at a roughly 20% discount to fair value currently.