U.S. investors are suddenly attuned to inflation risks and how to protect against them.
Inflation is on a rampage, with consumer prices soaring 9.1% for the 12 months through June, a 40-year high.
It’s been an abrupt and shocking change after years of low inflationary pressures accompanied by substantial growth and asset price gains.
So how can investors cope with this scourge?
Christine Benz, Morningstar’s director of personal finance, has written an analysis of investments that can protect you from inflation. Among the keys:
Treasury Inflation-Protected Securities (TIPS) and I Bonds
“TIPS and I Bonds offer the most direct inflation-hedging of any investment type,” Benz said. “Both offer an interest rate as well as an added return to help the value of their investors’ accounts keep pace with [inflation].”
Specifically, “if inflation, as measured by the consumer price index, goes up, the owner of a TIPS receives an increase in his/her principal value,” Benz explains. “If inflation goes down, the principal value goes down, too.”
I Bonds have an inflation kicker too. “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,” Benz said.
There is an important tax difference between TIPS and I Bonds. “TIPS holders receive semiannual interest payments, whereas I-Bond holders receive their accrued interest when their bond matures or they redeem it,” she said.
“I Bonds offer tax deferral because of that feature.” I Bond holders don’t have to pay taxes on their interest income until the bond is redeemed.
Commodities
“Commodities-tracking investments … have delivered in this year’s inflationary spike,” Benz said. “The typical broad basket commodities-tracking fund has gained 15% on average. In other words, their returns have nicely offset inflation and then some.”
But, “commodities-tracking investments tend to be much more volatile than TIPS and I Bonds,” Benz pointed out. “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 stays high, commodity prices can stay high too. “But if recessionary worries pick up steam, commodities prices could drop in a hurry, harming new buyers,” Benz said.
“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.”
Commodity-Related Stocks
Companies that produce and distribute commodities tend to benefit during inflationary cycles too, Benz explained. “Stocks of energy companies, for example, have soared more than 50% over the past year, by far the best-performing major equity sector,” she said.
“Commodities-related stocks have an advantage over pure commodities-tracking investments 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.”
Real Estate Investment Trusts (REITs)
“REITs have historically fared reasonably well as inflation hedges,” Benz said. That’s because the real estate owners “are often pushing through rent increases, which in turn enhances REIT payouts and security prices, at times when inflation is running up,” she said.
“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.”
