Dealing with Inflation, Part 2: How to hedge against inflation — if you must

Dealing with Inflation, Part 2: How to hedge against inflation — if you must

As this is written (mid-2013), a rapid uncontrollable increase in inflation is really unlikely; see $tarrBuck July 17 and August 31, 2013. But if you’re still worried, for investors who want to be prepared for significant inflation risks, there are asset choices that make sense —- and some panicky choices that don’t. Inflation is an increase in prices and wages, degrading the value of fixed monetary assets. An increase in inflation will usually be accompanied by an increase in interest rates.

Thumbnail summary: I-bonds from the US Treasury are virtually perfect inflation protection, but they are limited in the quantity any individual can buy. TIPS (Treasury Inflation Protected Securities) are an excellent inflation hedge but subject to market price risk. Real estate and common stocks appreciate with inflation over long periods of time, but there’s no guarantee that the market will be accommodating when you buy or try to sell. Gold is a traditional safe refuge from war and inflation, but the price of gold is really unpredictable and often fails to track inflation. Bonds, preferred stocks, and long term fixed-rent leases are severe victims of inflation. They don’t belong in an inflation-safe portfolio.

Real assets (real estate, common stocks) eventually appreciate in money-value to retain real value under inflation. But timing the market, both for buying and selling may be tricky: inflation disrupts markets. And for all inflation hedges, gains in dollar value — merely reflecting the increase in prices and decline in value of the dollar — are subject to income taxation on the increase in money value.

The Range of Assets and How They Move with Inflation
Bonds: Increasing inflation and the rising interest rates that accompany increasing inflation can cut a long bond’s market value in half. That’s not because of a reduction in credit-worthiness of the borrower. The bond will still be repaid. It’s just that with an increase in other interest rates, an older low-interest rate bond becomes less attractive. On maturity, the repayment of principal is in dollars depreciated by inflation. Long-term bonds should not be in your inflation-safe portfolio.

Cash, CD’s, T-bills: Currency or assets of fixed money-value and fixed yield (CD’s, Treasury bills, bank deposits) are directly subject to inflation. But those assets are very liquid. You can turn them immediately into spendable money and reinvest in an inflation hedge. Interest rates track inflation rates but, unfortunately, the increase in interest rates may not be enough to compensate money holders for the loss of purchasing power. Staying in short term holdings and rolling them over regularly to the highest yielding cash alternative is an imperfect, but conservative, inflation strategy. Buying a succession of 6-month Treasury bills and rolling them over as they mature should contain, but not eliminate, losses due to inflation.

Real estate: Owning your own home is an inflation hedge. Owning income property with rents that can be adjusted regularly is similarly an inflation hedge. Income property, leased with a rent fixed in dollar terms far into the future leaves little room for inflation protection until the lease expires.
Since buying a home or income property is an inflation hedge, buyers may bid up the price of real estate by more than the increase in the general price level, reflecting anticipated future inflation and the favorable tax treatment of mortgage debt. But selling your real estate during an intense inflation may be tricky. As interest rates increase with inflation, prospective buyers may find borrowing to finance a purchase becomes difficult and expensive.

Gold: Gold is the traditional inflation hedge. In the 19th and early 20th centuries, gold was money. But now money is government-issued paper. The value of gold rises and falls with the willingness of buyers to buy and hold. Nothing supports the price of gold but the price expectations of current and future gold owners and buyers. Since gold’s price peaked in 1980, the price has increased but it has not kept up with inflation.

Common Stocks: Common stocks are a good inflation hedge over long periods of time. Eventually increases in inflation show up as an increase in the dividends and share prices of common stocks. But over a few years or even a decade stocks can fail to protect you. High inflation rates lead to high interest rates and high interest rates depress stock prices as common stock earnings and dividends compete with high yielding bonds.

I-bonds: I-bonds are savings bonds from the US Treasury, including repayment from the Treasury timed at the holder’s option. Currently, I-bonds pay zero interest but there’s a big plus: the redemption value fully represents the accumulated inflation from the time of purchase to the time they’re cashed out, and the proceeds are taxable only when they are cashed. There are restrictions on I-bonds: maximum $10,000 purchase per person per year; I-bonds are illiquid for the first year; there’s an interest penalty for cashing out during the first five years. For up to $10,000 (annually) in wealth, I-bonds provide full inflation protection, good liquidity, and no possible loss of monetary value.

TIPS (Treasury Inflation Protected Securities): TIPS are US Treasury bonds whose principal grows with inflation. Interest is paid on the inflation-adjusted principal; inflation-adjusted principal is repaid on maturity. From issue date to maturity, this is as perfect as inflation protection can be.
What’s the downside? If you want your money prior to maturity, or if you buy on the secondary market, you may take a loss as market prices vary. Diversification can make the TIPS portfolio less risky: laddering and dollar-cost-averaging. ‘Laddering’ means holding a range of maturities. Dollar cost averaging means spreading the timing of purchases over several years. A TIPS mutual fund can manage TIPS holdings for you.

Inflation Protection for Worried Wealth
So what should an inflation-worried wealth holder do? Avoid long bonds and owning property with a long fixed-rent lease. Don’t rely on gold, its price is simply unpredictable. Real estate and common stocks will protect you from inflation over long periods of time, but may not provide you with the money you need when you need it. Stock and real estate markets can be unpredictable so timing the market for favorable buying and selling opportunities is risky. I-bonds are perfectly predictable and for up to $10,000 per year per person, they provide genuine inflation protection. For larger amounts of money, a laddered portfolio of TIPS from diverse purchase dates provides a mix of inflation protection and moderated market risk.

Copyright © 2013, Ross M. Starr


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