Portfolio Construction
Protecting your portfolio from the risks of inflation
David Hoag
Fixed Income Portfolio Manager

For most of the past decade, fixed-income investors have benefited from extremely low inflation. Consumer prices rose less than 1% last year and have topped 3% only twice since 2005. That’s helped to push down bond yields and boost the value of fixed-income portfolios. While inflation is unlikely to skyrocket, consumer prices could begin to move higher as the U.S. and global economies improve.

The potential for higher inflation underscores the need to safeguard portfolios. Even moderately rising prices can erode the purchasing power of savings that have been carefully built over many years. Regardless of economic or market conditions, it makes sense to hold some inflation protection within a portfolio.

In the portfolios that I manage, I allocate a certain percentage to bonds that guard against inflation called Treasury Inflation Protected Securities, or TIPS. These securities are issued by the U.S. Treasury Department and their value moves in lockstep with inflation. The principal value of TIPS, and their semiannual coupon payments, are both adjusted for changes in the U.S. consumer price index (CPI). For example, if a newly issued five-year TIPS bond was bought at par ($100) and inflation rose 5% in each of those five years, the value of the bond at maturity would be a little more than $125.

Loose monetary policy has increased the threat of inflation.

I believe the need for vigilance is especially important given the Federal Reserve’s unprecedented steps in recent years to spur the economy. The flip side of the Fed’s generous monetary policy is a heightened risk of inflation. Simply put, I think the probability of an unexpected pickup in consumer prices is rising. Indeed, inflation expectations have ticked up in the last few months as oil prices have partially rebounded from their lows. Even though some economic reports have been weaker than expected, that’s had the counterintuitive effect of adding to inflationary fears. The market is concerned that a further Fed delay in raising interest rates could intensify underlying inflationary pressure that will flare up down the road.

To understand how TIPS work, let’s compare them to conventional Treasuries. With a traditional bond, investors pay a fixed amount upfront. They receive regular interest payments during the life of the security and get back their original principal when the bond matures. A benefit is that investors know precisely how much they will receive in coupon payments and how much they’ll get back at maturity. However, if consumer prices move higher during that period, an investor’s purchasing power could be greatly reduced in inflation-adjusted terms.

TIPS preserve purchasing power by paying a guaranteed return in addition to the rate of inflation. They are widely used by large institutions that need to hedge against long-term inflation risk. Insurance companies, pension funds and endowments all rely heavily on inflation-indexed securities to help them meet future obligations. A great TIPS feature is that if the unexpected occurs, and consumer prices fall into a deflationary pattern for an extended period of time, investors get back the full value of their original investment. In other words, if inflation strikes, the principal of a TIPS bond moves up alongside it. If deflation occurs, the principal remains at par and does not go down.

There are some potential risks with TIPS. As with all fixed-income investments, inflation-indexed bonds are sensitive to shifting interest rates, and their value would decline in a rising-rate environment. In such a scenario, however, inflation-indexed securities are likely to fare better than conventional bonds. Also, because a majority of the benefit from TIPS comes in the form of rising principal, coupon payments are lower than those of traditional Treasuries.

The relative appeal of TIPS versus traditional Treasuries is determined by a figure known as the break-even rate, which measures the yield differential between TIPS and conventional bonds of the same maturity. The break-even rate basically gauges what the world thinks inflation will be. If inflation exceeds the threshold in coming years, then TIPS will have benefited those who hold them relative to traditional Treasuries. The current break-even rate for 10-year Treasury notes is 1.86%. If actual inflation is closer to the Fed’s intended target of about 2% growth in CPI, then inflation-linked bonds would be a better investment than conventional bonds of the same maturity.

TIPS offer explicit inflation protection.

Some other asset classes — primarily equities — offer a potential refuge from inflation. Over time, stocks have been a viable hedge, partly because the rising prices that consumers pay at the cash register translate into higher revenue on corporate income statements. However, there are drawbacks to relying on equities. Stocks are usually far more volatile than fixed-income, increasing the risk for people in or near retirement who may need access to their money in the short-term. Also, stocks sometimes don’t cushion the blow of inflation. Contrary to conventional economic theory, there have been periods when consumer prices spiked despite lackluster growth and sluggish corporate earnings. In those instances, inflation rose so sharply that it stunted economic growth and pushed down stock prices. TIPS have historically had a low, and sometimes even negative, correlation with other asset classes, making them an attractive hedge.

An added appeal of TIPS at the moment is attractive valuations. Investors have pulled money from inflation-linked securities in the last two years as soft global growth has kept a lid on consumer prices. The resulting valuations have provided the opportunity to acquire securities at favorable prices.

I believe that TIPS are an important building block that can help clients round out their fixed-income portfolios. As with most investments, it’s best to establish an allocation long before a trend becomes widely apparent to the market. It’s all-too-easy during periods of modest inflation to forget about the damage that rising consumer prices can inflict on a portfolio. But history has shown that consumer prices can spike quickly and with little advance warning. Investors who safeguard their portfolios well in advance would be better positioned to withstand damage from rising inflation.

David Hoag is a fixed income portfolio manager with 31 years of investment experience. He holds an MBA from the University of Chicago and a bachelor's degree from Wheaton College.

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