Planting an Inflation Hedge

The outlook for inflation, says the new Fed chairman, Ben Bernanke, "is reasonably favorable but carries some risks." For investors, inflation always carries risks, and now those risks have intensified. The consumer price index, the benchmark for inflation, rose just 2.3% in 2003, but it increased 3.4% in 2005 and at an annualized rate of 5.1% during the first four months of 2006. Why all the concern with such small numbers? Because the power of compounding over time is awesome.

Worth less. Even at 3% inflation, the buying power of today's dollar loses more than half its value in 25 years. In other words, if you are 40 now and expect to retire at 65 with $1 million, the annual payout from your nest egg -- assuming it generates income at 6% a year -- will be worth less than $30,000 in 2006 buying power. Is that enough to live on?

Even worse, in times of high inflation, making money in both the stock and bond markets has been difficult, so you might not accumulate your million bucks in the first place. The good news, however, is that there are ways to protect yourself against inflation -- and even profit from it.

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First, understand that while inflation hurts all financial assets, it's bonds that usually get pummeled more than stocks. When you buy a bond, you make a loan -- let's say for $1,000 over a ten-year period. The borrower agrees that, at the end of ten years, he'll pay your $1,000 back. Even if inflation is only 3%, the buying power of that $1,000 in a decade will be less than three-fourths of what it is today. So, to compensate you, the borrower pays interest along the way.

If inflation is low when you make the loan and is expected to remain low ten years later, then the interest the borrower pays may be fixed at 5%. Now, let's assume that a couple of years later, inflation expectations rise and new bonds like the one you bought are issued at 7%. Your 5% bond isn't worth as much, and if you sell it before maturity, you'll take a loss. Even if you hold on to the bond, the results won't be any better because if inflation stays high, the interest you'll collect won't make up for the decline in your purchasing power.

For example, during the worst five-year period for inflation in modern history -- 1977-81, when the CPI rose at an annualized rate of 10% -- the value of long-term U.S. Treasury bonds fell by an average of 1% a year, including interest payments and price declines.

What's the antidote, you ask? Stocks. Over the same five years, large-company stocks, represented by Standard & Poor's 500-stock index, returned an annualized 8%. Or consider a longer time span. From 1973 to 1981, long-term T-bonds produced negative returns after inflation in seven of nine years, and the purchasing power of an investment of $1,000 was cut nearly in half, to $564. Stocks didn't do well either, but they outstripped bonds by more than one-fourth. The irony is that bonds are often seen as a safe haven. But in times of inflation the certainty of being repaid at maturity is cold comfort.

Power of ownership. Stocks do better because they represent a claim on the profits of a business. Inflation increases a firm's costs by increasing its expenses, but the business can usually pass on those higher costs to customers.

So, with inflation on the horizon, I would much rather own stocks than bonds, especially stocks of companies that appear to have the power to raise their prices without much resistance -- for example, a soft-drink maker with a strong brand name, such as Coca-Cola (symbol KO), or a company that earns a consistent proportion of a growing pie, such as advertising firm Omnicom Group (OMC).

But don't toss your bonds overboard. In 1996, The Journal of Portfolio Management published an article by David A. Levine titled "The Benefits of Rising Interest Rates." Levine argued that although the price of bonds declines with rising rates (and rising inflation), the income from those bonds can increase if they're managed well.

For example, say you own a single Treasury note that matures in 2014 and carries a coupon of 5%. Assume that rates rise over the next two years. You sell the 2014 bond at a loss (taking the tax benefit) and buy a new bond that matures in 2016 and carries a coupon of 6%. The additional income over the life of the bond will compensate you for the after-tax capital loss.

Ladders, TIPS and bonds. Another way to protect yourself: Ladder your bonds. Own a series of notes that mature every year for the next ten years. As the first one matures, use the proceeds to buy a note that matures in another ten years. If rates are rising, the new bond will pay a higher interest than all the others.

You can also buy TIPS, or Treasury inflation-protected securities, which pay a guaranteed "real" rate of interest plus an inflation kicker that increases each year with the rise in the CPI. For example, on May 1, the Treasury issued a five-year TIPS note that carried a real rate of 2.375%. If inflation averages 4% until maturity, your annual return will exceed 6%. By comparison, a conventional T-note maturing in April 2011 was yielding 4.875%. In other words, investors in T-notes at the end of April were betting inflation would average about 2.5%. If you think there's a decent chance it will go higher -- as I do -- then buy TIPS.

You can purchase TIPS through a banker or a broker, or at www.treasurydirect.gov. Or you can purchase shares of a mutual fund such as Vanguard Inflation-Protected Securities (VIPSX), which owns a portfolio of 18 separate TIPS issues and charges annual expenses of 0.20%. Just be aware that the Vanguard TIPS fund is volatile -- 20% more so than Vanguard Intermediate Treasury fund and nearly four times more volatile than Vanguard Short-Term Treasury.

Yet another way to take advantage of rising interest rates is by owning a portfolio of bank loans made at adjustable rates. A good example is Nuveen Floating Rate Income (JFR), a closed-end fund that trades like a stock on the New York Stock Exchange and currently yields 7.8%. But be aware: If inflation takes off, it could hurt some corporations that have borrowed money, endangering their ability to pay back their bank loans. Recently, the Nuveen fund sold at an 8% discount to net asset value per share, which means you can buy $1 of its assets for 92 cents.

Commodities, such as gold, copper, wheat and pork bellies, also tend to rise with inflation. Trading highly leveraged contracts to buy and sell commodities in the futures markets is an extremely risky business that I do not recommend. But you might consider investing in Pimco CommodityRealReturn Strategy (PCRAX), a mutual fund that is linked to a popular commodity index through the use of derivatives. Five other firms offer similar funds, but Morningstar calls Pimco "the best commodity option available to retail investors." I agree. The fund returned an annualized 21% for the three years to May 1. You can buy the Class D shares with no commission or transaction fees through many discount brokers.

You can invest in commodities less directly by buying shares of no-load T. Rowe Price New Era (PRNEX), a venerable mutual fund (I have owned it for 25 years) that buys natural-resources stocks. Holdings include Diamond Offshore Drilling, Arch Coal, Alcan (aluminum) and Newmont Mining (gold). Over the past three years, New Era returned an annualized 38%. Its expense ratio is 0.68%.

Stock picks. As for individual stocks, J. Jeffrey Auxier, who manages Auxier Focus (AUXFX), a large-company value fund that has returned an annualized 9% over the past five years, is especially fond of those that can take advantage of the rising prices of timber and agricultural commodities. He likes Blount International (BLT), which makes forestry equipment, and AGCO (AG), a large maker of farming equipment. Blount has a price-earnings ratio of 14, based on projections of year-ahead earnings; AGCO's P/E is 16.

The explosion in trade and technology has brought a flood of supply that may keep a lid on prices even with rising demand, as India and China improve their standards of living. And there's no doubt that central banks are loath to let money depreciate the way it did in the 1970s.

I doubt, however, that high inflation has been vanquished forever. The smart move is to have assets that can weather inflationary storms if they start blowing.