How to hedge against inflation with TIPS and other investments

Inflation will be in the spotlight on Wednesday as investors analyze the latest consumer price index. The numbers may be another sign that inflation remains a persistent problem.

It’s a tough situation for investors looking for protection, but there are some good ways to get it.

Treasury Inflation-Protected Securities (TIPS) are an option whose “real” yields are currently at multi-decade highs. In addition to TIPS, analysts suggest other products, infrastructure, and other assets that can hedge against rising prices.

Inflation is well below the 2022 peak of 9.1% due to the supply shock caused by the coronavirus pandemic, but remains well above the Federal Reserve’s 2% target. The composite consumer price index in September is expected to reach 3.6%, due in part to rising energy costs due to the war with Iran. The Federal Reserve’s recommended personal consumption expenditure index had a core rate of 3% in August.

Americans are also increasingly concerned about inflation. The New York Fed’s Consumer Expectations Survey showed the one-year inflation outlook rose to 3.9% in September, the highest level since May 2023.

Despite its name, TIPS doesn’t offer much inflation protection this year. of iShares TIPS Bond ETFtracks the ICE U.S. Treasury Inflation-Protected Bond Index, which has a total return of -1.16% year-to-date.

Like most other bonds, TIPS have been hit hard by rising interest rates, with the 10-year Treasury note recently hitting a multi-year high of about 5.3%. Bond prices and yields moved in opposite directions, and many TIPS funds suffered as interest rates rose.

But rising yields are making TIPS even more attractive. The 10-year TIPS yield is now 2.87%, the lowest it has been since November 2008, after closing at 2.951% on Oct. 5, according to Tradeweb.

“It’s an interesting situation given the interest rate situation,” said Jason Draho, head of asset allocation for the Americas at UBS Global Wealth Management.

TIPS pay a fixed coupon, or interest rate, but the principal value of the bond increases as inflation rises. This adjustment reflects changes in inflation based on the nonseasonally adjusted All-City Consumer Price Index with a three-month lag.

As a result, TIPS investors earn interest on a higher principal value over time. This is the essence of protection compared to traditional government bonds.

TIPS’ poor performance this year is not due to rising inflation expectations. Almost all of the increase is due to an increase in real yields, which are nominal yields minus expected inflation. Real yields are rising due to factors such as strong economic growth and the U.S. budget deficit, which is about 6% of gross domestic product (requiring much more government borrowing).

If nominal interest rates were rising solely due to inflation, TIPS total return, which combines yield and price, should be fine, said RJ Gallo, chief investment officer of global fixed income at Federated Hermes. But that’s not the case.

“TIPS generated a total return loss because accrued profits were insufficient to offset the price decline caused by the potential increase in real yields,” Gallo explained.

Draho points out that TIPS with maturities of 10 years or more are highly sensitive to duration risk. “If you buy TIPS, especially long-term bonds over 10 years, you’re making a big statement that interest rates won’t go up any further,” he said.

The bullish case is that inflation falls faster than expected. Draho points out that based on short-term Treasury yields, that’s not what the market expects. But if inflation eases next year, as he expects, the yield curve will adjust downward.

One way to manage duration risk is to own individual TIPS rather than a fund that must maintain a duration that matches a benchmark index. Investors can create TIPS bond ladders with varying maturities to suit their income needs over the next 10 years, for example.

Holding TIPS to maturity may result in price fluctuations, but you will receive the greater of the principal value or the inflation-adjusted price at the bond’s maturity.

Greg Sharenow, portfolio manager at PIMCO, said short-term TIPS look attractive because they offer more protection against rising interest rates.

“As a company, we are of the view that inflation will eventually decline, but that view continues to strengthen as real-world events unfold,” he said. “Over the past five to seven years, we’ve seen many times in the third supply shock that we’re currently in, where prices actually end up being undervalued relative to the actual rate of inflation,” he added.

Funds that focus on short-term TIPS include: Vanguard Short-Term Inflation-Protected Securities ETF, iShares 0-5 Year TIPS Bond ETF and PIMCO 1-5 Year US TIPS Index ETF.

Of course, tips aren’t the only way. Rick Rieder, BlackRock’s chief investment officer for global fixed income, offers a diversified strategy that includes stocks, commodities and alternative assets.

“I would think about accumulating more income, keeping the interest rate exposure reasonable, and then using the kind of alternatives that many people use to balance out their portfolios,” he said. “It makes a lot of sense to me.”

Broad anti-inflation funds include: State Street Multi-Asset Real Return ETF, Fidelity Strategic Real Return Fund and PIMCO Inflation Safe Multi-Asset Fund.

PIMCO Fund holdings include TIPS, commodities, gold, and real estate investment trusts.

“The idea is to have a lot of different exposures to get a more balanced return, without having to try to get exactly the right asset class at a particular moment,” said Sharenow, the fund’s manager.

He added that he believes there is “great value” in TIPS, which make up the largest portion of the portfolio. The next largest holding is commodities. There is price “pass-through,” which is the extent to which companies can pass costs on to customers through price increases. That is beneficial for investors, he noted.

Separately, the fund holds about 10% each in gold and REITs.

Draho bases his commodity recommendations in part on long-term asset allocation studies, including the 1970s, when inflation was much higher. “In the long run, we can reduce risk and improve diversification,” he said. “The benefits were most pronounced when inflation was higher than expected.”

He suggests having a constantly balanced basket rather than picking individual items. For example, gold and oil perform well in a variety of economic and monetary policy scenarios, but getting the timing right can be difficult.

Commodity ETFs to consider include: Invesco Optimum Yield Diversified Product Strategy ETF (PDBC) and iShares S&P GSCI Commodity Index Trust (GSG).

Another asset class Draho suggests is infrastructure, or operators of roads, ports, bridges, and other hard assets. Companies in this sector tend to be rate collectors, collecting long-term revenues based on contracts that include inflation riders and built-in price adjustments.

Investors can gain exposure to infrastructure through ETFs such as: iShares Global Infrastructure ETF (IGF) and ProShares DJ Brookfield Global Infrastructure ETF (Tolts).

Mr. Drajo is not sounding the alarm on inflation, but says it makes sense to add protection against further rises.

“The risk now is that there will be a supply-side shock that could push inflation back up,” he said.

— CNBC’s Daren Fonda contributed reporting.