Morningstar's Top Picks for Inflation Protection

Investors don't seem too bothered by inflation, and could you blame them?

In early 2016, extreme equity-market volatility was tied to concerns over lackluster global growth, not worries that the U.S. or any other major economies were overheating. Indeed, inflation, as measured by the Consumer Price Index, has been running persistently below the Federal Reserve's 2% target for more than four years, an outgrowth of slack demand for commodities, especially energy. The oil glut in the U.S. was recently so great that traders have resorted to storing oil in rail cars.

Given those facts, it would be hard to blame investors for taking their sweet time--or not bothering at all--to build a bulwark against inflation in their portfolios. But there have recently been some indications that inflation could be perking up. As Morningstar's Bob Johnson wrote in this report, the Fed's favored metric of inflation, the Personal Consumption Expenditure metric, accelerated sharply in January.

Investors' growing interest in inflation is reflected in the widening differential between the yield on 10-year Treasury bonds and 10-year Treasury Inflation-Protected Securities, which is often viewed as a proxy for investors' inflation expectations. After scraping bottom in early February, the differential has widened substantially over the past month, to 1.5% as of March 4. That indicates that investors' inflation expectations are trending up. If inflation runs higher than that, the TIPS buyer will be the winner versus the purchaser of nominal Treasury bonds.

Of course, that's an ultrashort time period by which to judge the prospects for inflation; it's possible that investors' concerns about rising prices could retreat just as quickly as they arrived. It's also true that not everyone needs inflation hedges in equal measure. Young people who are still earning a paycheck have less of a reason to be concerned about adding direct inflation protection to their portfolios than retirees. Not only are workers eligible for cost-of-living increases through their paychecks, but the equity-heavy portfolios that younger people commonly employ will, over long periods of time, likely outgain inflation. By contrast, investors who are relying on their portfolios to supply their living expenses and who have heavy stakes in nominal bonds have more of a demand for inflation-fighting investments. It's also worth noting that the consumption baskets of seniors tilt more heavily toward goods and services that have been experiencing higher rates of inflation, such as healthcare and rental expenditures. (This article explores the extent to which an allocation to inflation hedges should vary by personal situation.)

With that in mind, let's take a closer look at Morningstar analysts' best ideas for hedging against inflation, ranging from direct hedges like TIPS to indirect hedges like bank loans.

Direct Hedges: TIPS and I Bonds The thesis: Both Treasury Inflation-Protected Securities (TIPS) and I Bonds are considered direct inflation hedges because they compensate investors for increases in inflation over their holding periods. With TIPS, investors receive an adjustment to principal to reflect inflation; with I Bonds, the yield is adjusted to reflect CPI.

Morningstar's top picks: Investors can buy I Bonds directly from TreasuryDirect.gov, and that's arguably the simplest and most straightforward way to obtain exposure to inflation-protected bonds. However, new purchases are subject to annual limits of $10,000 for electronic versions and $5,000 for paper bonds, and the latter can only be purchased through tax refunds. That means that, in practical terms, large buyers will have a difficult time amassing a meaningful stake in I Bonds.

For Treasury Inflation-Protected Securities, Morningstar analysts have generally recommended that individual investors consider mutual funds rather than buying individual TIPS due to trading complexities in the latter. Among Morningstar's favorite funds are

Know before you go: Before buying a TIPS fund, investigate its duration, a measure of interest-rate sensitivity; many core TIPS funds feature a fair amount of rate-related volatility and are, therefore, most appropriate for investors with holding periods of at least five years. Also, note that some intermediate-term bond funds have been buying TIPS of late; Morningstar's portfolio breakdowns for bond funds gives you a sense of whether you already own TIPS via your general bond fund. (The Barclays U.S. Aggregate Bond Index doesn't include TIPS; so if your core bond exposure is an index fund, you can safely add to TIPS without duplicating your efforts.) Like all taxable-bond types, TIPS funds are best housed in a tax-sheltered account like an IRA, because their inflation adjustments are taxed as ordinary income.

Indirect Inflation Hedges: Bank Loans The thesis: Bank loans don't provide a direct hedge against inflation, but their returns have tended to be positively correlated with inflation. That's because the loans they invest in have interest rates that "float" along with the London Interbank Offered Rate (Libor); when Libor is trending up, inflation is often on the move, too.

Morningstar's top picks:

Four bank-loan funds currently receive Morningstar Analyst Ratings of Bronze, including

Know before you go: Bank loans tend to be lower quality and, as such, they usually behave in sympathy with the U.S. economy and the equity market. Thanks to terrible losses among the category's junkiest and least-liquid entrants, the average bank-loan fund lost a stunning 30% in 2008. Clearly, bank loans are no substitute for high-quality bond exposure. And because their income payouts have the potential to be high, bank-loan funds are best housed in a tax-sheltered account like an IRA.

Indirect Inflation Hedges: Commodities-Tracking Investments The thesis: Commodities investments enable investors to participate in the price gains (and losses, recently) of commodities. When inflation is running high and eroding investors' purchasing power, a commodities investment can gain, helping to offset those price increases.

Morningstar's top picks:

Morningstar's top-rated commodities mutual funds are both from PIMCO:

Know before you go: Commodities are extremely volatile and the slide in energy and basic-materials prices globally has shown them at their worst. The typical commodities fund has lost 14% on an annualized basis during the past five years. Commodities-futures funds are best held in tax-sheltered accounts, as gains are treated as 60% long term and 40% short term (taxed at your ordinary income tax rate).

Indirect Inflation Hedges: Real Estate The thesis: Whether you own it directly or indirectly, real estate is generally considered an inflation hedge because real estate prices often move in sync with the general inflation rate. Moreover, owners of rental properties, like the office buildings and shopping malls that populate REITs, can charge higher rents in inflationary environments.

Morningstar's top picks:

Morningstar has two Gold-rated REIT funds--

Know before you go:

If you own a total market index fund or a good value fund, chances are you already have some real estate exposure.

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