Tuesday, March 17, 2009

Inflation

I have no idea if we're going to suffer from high inflation in the near future or not, so I don't anticipate placing a large bet either for or against it. However, for those folks who are convinced that the value of the dollar is about to take a dive, I can suggest some relatively low-risk funds. Depending on one's certainty or fear level, these can either be a small part of a diversified portfolio, or a larger part of an anti-inflation strategy.

Treasury inflation-protected securities (TIPS) are Treasury bonds that are linked to the rate of inflation, meaning that both the underlying principal of the bond and the interest payments are adjusted up or down in proportion to the rate of inflation/deflation in the U.S. This is obviously a very attractive investment when inflation hits, because the holder will earn real interest when other fixed-income investments are effectively losing value. Of course the reverse is also true, as deflation in the U.S. will cause TIPS to actually lose value relative to other bonds.

Access to TIPS funds varies between accounts. For Roth IRAs and taxable accounts there is an exchange traded fund composed entirely of TIPS with an easy-to-remember symbol: TIP. (Right now TIP has an impressive dividend yield of 5.9%.) In the case of limited accounts, (401(k)s, 403(b)s) some institutions offer TIPS funds while others don't, so anyone in this category who's interested in TIPS should check with his provider.

I don't necessarily recommend TIPS as hedges against financial Armageddon, because the government's ability to increase payments to TIPS holders depends on whether or not it has sufficient funds in the first place. In addition, any general sell-off of U.S. Treasury bonds will affect TIPS prices. Nonetheless, I think TIPS may be the safest liquid hedges against inflation because they pay interest and don't involve derivatives. In the case of limited accounts they're usually the only hedge.

Now if only I knew how to predict inflation...

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