Friday, May 29, 2009

More inflation Talk

Good article in Seeking Alpha today  if you're interested in adjusting your portfolio for inflation (and it seems like traders have done exactly this all month long):

With inflation worries starting to surface and the US Dollar resuming its fall, many investment advisors have advocated the iShares Barclays TIPS Bond Fund (TIP). This ETF invests in Treasury Inflation Protected Securities, treasury bonds which promise to completely protect against inflation by calculating the coupon payment on inflation-adjusted principal.

The TIP is a smartly designed fund with an attractive expense ratio and plenty of liquidity. But it has one fatal flaw: TIPs haven't been tested in truly inflationary times, and are thus a much riskier investment than most people think.

The protective value of TIPs rests on an accurate calculation of inflation. Critics have long accused the CPI of underestimating the true value of inflation. Much like the unemployment figures, the CPI numbers have beenopenly massaged over time to look more benign. They aren't falsified per se, the index's parameters are simply changed in a way that produces overly conservative figures.

TIPs were first issued in 1997, smack in the middle of the "great moderation". They weren't tested in the 1970's. We don't know if the US government will pay them back honestly and in full. It may simply be easier and cheaper to lower the CPI numbers, leaving TIPs holders exposed. This excellent Bloomberg story describes how poorly TIPs performed in early 2008, right when pre-crisis inflation hit its peak.

The pressure on the US government to fiddle the inflation numbers will be overwhelming the next time inflation rears its head. The Fed wants to keep rates low to support growth. The Treasury wants to keep rates low to avoid raising its borrowing costs, both through higher interest payments and higher TIPs payouts. Every government in the world fudges their inflation numbers, and history has shown that the worst fudging comes in times of the worst inflation. With the US fiscal situation looking more and more dire, investors cannot rely on the flawed CPI to protect them.

Better, safer alternatives exist. The SPDR DB International Government Inflation-Protected Bond Fund (WIP) invests in inflation protected securities from a variety of non-US issuers. WIPs holdings are better credit risks, and their geographic diversity minimizes the chance that any one particular government will hurt your returns.

The ProShares Ultra Short 20+ Year Treasury (TBT) shorts the long end of the US treasury curve . Unlike the CPI rate, long term treasury rates are set by the market. (Although the federal reserve has recently tried to artificially support prices with quantitative easing, its policy has clearly failed.) As inflationary expectations rise investors will demand more yield for long term treasuries, causing prices to fall and TBT to rise.

Investors with more risk tolerance may want to invest directly in commodities, which are usually big winners in inflationary environments. Top picks would include the SPDR Gold Shares Trust (GLD), the Powershares DB Commodity Index (DBC), and the Powershares DB Agriculture (DBA). If you absolutely must invest in TIP, make it a small part of an inflation proof portfolio that includes exposure to international government bonds and commodities.

Disclosure: Author owns TBT.