The Fed may quickly subdue inflation, or it may fail. Here are some devices to protect your retirement savings in case of failure.
By William Baldwin, Senior Contributor
Inflation is here to stay for a while. At 3%, a moderately pessimistic estimate of where it will settle, it doubles the cost of living over 24 years. At 4% it would quadruple costs over the course of 36 years, which is maybe how long the money you put in your retirement account today will sit until you spend it.
Herein are a dozen antidotes to inflation. They vary greatly in their response to a rising CPI but they have this in common: risk. There is, alas, no way to combat the risk of runaway inflation without taking other risks.
Diversification will help there. Use these in measured doses and use more than one. And pay attention to costs. Attached to each investment recommendation is a price in basis points, a basis point being 0.01% of annual holding cost ($1 a year per $10,000 invested).
Inflation Fighters
1. TIPS
Treasury Inflation Protected Securities guarantee to make you whole when the cost of living goes up. These government bonds pay a real yield, which is to say, a yield above and beyond the annual rise in the Consumer Price Index.
TIPS yields vary with maturity and are just above 2% for the longer-term issues. Your principal and the semiannual coupons are adjusted for changes in the cost of living. Both the coupons and the annual adjustments to principal are immediately taxable as interest.
That 2% yield is short of its all-time high but is immensely better than it was a few years ago.
Advantages: You have a high degree of certainty in the outcome, if you hold a bond until it matures. If it’s in a taxable account there’s no state income tax on the interest.
Disadvantage: If real rates rise, the bond’s market value will go down. That doesn’t mean anything to the investor who holds to maturity and refrains from looking at the market value shown on a brokerage statement. But most people do look at those statements. Brace yourself.
What to buy: If you are investing more than $100,000, buy either at one of the infrequent Treasury auctions or in the second-hand market. Fidelity Investments shows its customers a shopping list of 50 TIPS issues with very tight bid-ask spreads. Example: The 1-1/8% of January 2033 was recently quoted, per $100,000 of original par value, at $93,751 bid, $93,795 ask. With $44 of air space between these figures you can estimate the middleman’s markup at $22, or $4.70 per year if you hold to the end. That’s half a basis point.
If you are investing less than $100,000, use a fund. The Schwab U.S. TIPS fund is exchange-traded and runs up expenses of 4 basis points. The Vanguard Inflation Protected Securities Fund is similar but in the format of a mutual fund; you can get the cheaper share class (expense ratio: 10 basis points) if you put in $50,000.
Both the Schwab and Vanguard funds have portfolios with average maturities near 7 years. Unlike an individual bond, these funds don’t ever mature. They constantly roll over redeemed bonds into new positions. That can be good or bad, depending on which way interest rates go.
2. Stocks
The stock market provides no protection whatever against inflation in the short run. Look at what happened last year. Inflation went up, interest rates went up, bonds crashed and stocks crashed.
Over a long period, though, corporate earnings and corporate values do have a way of overcoming a weakness in the dollar. If you are investing now to cover a nursing home bill in 2059, stocks are a hedge against inflation.
Advantage: nice returns. It is reasonable to expect you’ll average almost double the 2% real return you get on TIPS.
Disadvantage: fluctuations. Stocks got mauled in 2000-2002, 2008-2009 and the spring of 2020.
What to buy: Vanguard Total Stock Market and iShares Core S&P Total U.S., exchange-traded funds, run up costs of 3 basis points. Schwab and Fidelity also have cheap index funds.
3. Short-Term Bonds
When inflation delivers an unpleasant surprise, all bonds suffer, but the ones with short lifespans suffer the least. You can lessen your portfolio’s exposure to unexpected inflation by replacing medium- or long-term bonds with short-term bonds. If interest rates go up in response to a faster-moving CPI, you (or your bond fund) will replace maturing bonds with new ones paying higher coupons.
At the moment, short-term rates are pretty high. The Vanguard Short-Term Treasury Index Fund, with an average maturity of 2 years, yields roughly 5%.
Advantage: low risk, especially if the portfolio buys only Treasury paper.
Disadvantage: the possibility of missing out. If rates go down, you’ll be reinvesting at lower rates.
What to buy: That Vanguard ETF costs 4 basis points. There are numerous competing funds with low expense ratios.
No harm in buying a short-term Treasury directly. Corporate bonds, however, should be held only in a fund, unless you are investing at least $50 million. You’d need $1 million positions to keep transaction costs down and you’d need 50 positions to diversify.
4. Commodities
A collection of futures contracts on crude oil, precious metals, lean hogs and whatnot will probably do well during a spike in inflation. Commodities performed during the run-up in inflation in the 1970s and again in 2022.
Advantage: scant correlation with stocks and bonds.
Disadvantages: (1) high volatility and (2) low confidence that this asset class will perform as expected in the next round of rising inflation.
What to buy: There are a lot of commodity funds, most of them overpriced. One of the cheaper choices is the GraniteShares Bloomberg Commodity Broad Strategy No K-1 ETF, at 25 basis points. Caveat: Like other K-1-free funds (meaning: they send you a 1099 tax statement instead of an annoying partnership form), this asset would be poisonous in a taxable account. In order to avoid the K-1 the fund uses an offshore subsidiary that converts long-term gains into ordinary income and makes capital losses unusable.
Hold your commodity fund in an IRA if you can. If it must go in a taxable account, use the Invesco DB Commodity Tracking ETF, taxed as a partnership. It’s expensive at 85 basis points.
Not a good idea to own futures directly. Forget to roll over a contract and you have 42,000 gallons of gasoline or the pigs to deal with.
5. Commodity Producers
In lieu of hard assets you can hold shares in companies that produce them.
Advantage: These outfits can make a profit even if the price of the commodity being sold goes sideways. Most of them pay dividends.
Disadvantage: Same volatility as for stocks generally, but worse. They get killed in recessions. Some have assets overseas that can be expropriated.
What to buy: Fidelity has two low-cost ETFs, priced at 8.4 basis points. Its MSCI Energy holds Exxon Mobil, Chevron, Schlumberger and other domestic fossil-fuelers. Its MSCI Materials has producers of industrial gases, paint, gold, lithium and other things.
For this part of your portfolio, direct purchase would make sense for someone who doesn’t need the convenience of a fund. Hold the shares in your taxable account. Buy into a dozen companies at a no-commission broker. Harvest capital losses from losers, repurchasing after 31 days.
6. Your Home
The Case-Shiller index says that since 1987 home prices have gained 1.5% a year in real terms (appreciation minus inflation). Along the way there have been crashes, in some areas severe, but it’s reasonable to expect residential real estate to more than keep up with the CPI.
On top of the appreciation you get an untaxed hidden dividend equal to the excess of the rental value over the sum of maintenance costs, property taxes and insurance. The occupancy yield varies enormously from house to house, and with how fussy you are about repainting storm windows, but 2% is a good guess. If that’s where you land, your total real return, per year, would be 3.5%.
Advantage: If your timing is good, leverage enhances your return. Someone sitting on a 3.5% mortgage is borrowing at a real cost not much more than 0%.
Disadvantage: Huge transaction costs. Also, if your timing is not so good, leverage might make you poorer. A mortgage at today’s rate has a real cost near 4%.
7. Precious Metals
Over the past century gold has more than kept up with the cost of living. Alas, over shorter periods it’s quite unreliable. It fared poorly in the 2022 inflation. Use sparingly.
Advantage: Has a tranquilizing effect on investors who don’t trust the Federal Reserve.
Disadvantage: Pays a negative dividend, in the form of whatever it costs to have an armed guard sitting outside the warehouse.
What to buy: SPDR Gold MiniShares. This ETF costs 10 basis points.
8. Junk
Bonds issued by sketchy corporations are plenty risky, since recessions bring on defaults, but they are less sensitive to sudden inflation than high-quality bonds of the same maturity. One reason is that a high coupon returns cash to the holder more quickly, shortening the rate sensitivity of the bond. Another is that inflation lightens the burden on overextended debtors, at least the ones with fixed-rate debt outstanding, and so reduces the risk of default.
Advantage: a way to diversify the risk in a fixed-income portfolio.
Disadvantage: defaults.
What to buy: The SPDR Portfolio High Yield Bond ETF costs 5 basis points. Over the past three years, Morningstar reports, it has averaged a return of 2.2% annually, against -4.7% for the Vanguard Intermediate-Term Treasury ETF.
9. Inflation Stocks
The Fidelity Stocks For Inflation ETF is an intriguing proposition. It holds shares of companies in industries that have historically weathered run-ups in the inflation rate. Technology, oil, pharma and metal production are prominent in the portfolio.
Advantage: Last year the fund went down less than half as much as the overall stock market.
Disadvantage: This four-year-old product hasn’t had time to prove itself.
What to buy: Like any ETF, this can be had in any brokerage account. Cost, 29 basis points.
10. Floating-Rate Loans
Portfolios of corporate loans with rates pegged to spot interest rates are almost immune to rising inflation.
Advantage: low rate sensitivity.
Disadvantage: unexciting yields.
What to buy: SPDR Bloomberg Investment Grade Floating Rate ETF, at a cost of 15 basis points.
11. Pipelines
Companies that transport fuel are somewhat resistant to inflation, since their fees are usually pegged to either the price of the commodity or to the CPI.
Advantage: They did well in 2022.
Disadvantage: Fossil fuels are going out of style.
What to buy: Tortoise North American Pipeline, an ETF priced at 40 basis points.
12. Real Estate Investment Trusts
The reason to own real estate, especially real estate financed in part with fixed-rate debt, is that rents drift up with the cost of living while mortgage payments do not. REITS are a diverse lot. They may specialize in apartments, offices, shopping malls, cell phone towers, warehouses or data centers. A fund with a REIT portfolio will probably cover a lot of ground.
Advantage: There is something to be said for the rising rent theory, at least over long periods.
Disadvantages: The industry is quite volatile. REITs did even worse than the stock market last year. Offices and malls may never recover from Covid.
What to buy: the Schwab U.S. REIT ETF, priced at 7 basis points.
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