As Uncle Sam’s debt has climbed to record levels, the printing presses at the Treasury Department have been working overtime, leaving many investors concerned that when the time comes to pay the piper, the inflationary price tag will be astounding. The experts are divided on the severity and timing of an uptick in inflation – some see deflation as more of a concern, while others are betting on 20% price increases – but the general consensus is that inflationary hedges are especially prudent in our current environment. What investors can’t agree upon is the best way to guard against runaway inflation, divided between gold, broad-based commodity funds, and inflation-protected bonds.
Gold prices have seen a significant run-up over the last year, as bouts of uncertainty have sent investors scrambling for a safe place to park their assets. Even after the rally, some well-respected pros remain bullish on gold, anticipating further turmoil and skeptical on projections for the return of growth in 2009. While many investors are buying gold to keep up with inflation, some disagree that precious metals provide an effective hedge in inflationary times, preferring oil, inflation-protected securities, and even currencies instead.
For investors worried about the significant run-up in gold prices over the last year, inflation-protected securities may be an appealing alternative as an inflation hedge. Treasury Inflation-Protected Securities (TIPS) are issued by the U.S. government, but unlike traditional Treasuries, their principal value increases with inflation, as measured by changed in the Consumer Price Index (CPI), or decreases with deflation. TIPS pay interest twice per year at a fixed rate, but since the coupon rate is applied to the adjusted principal, coupon payments are also correlated to inflation. Upon maturity, TIPS pay the greater of adjusted principal or original principal.
One of the largest fixed income ETFs available is iShares Lehman TIPS Fund (TIP), which tracks an index comprised of all U.S. TIPS that have at least one year remaining to maturity, are rated investment grade, and have $250 million or more of outstanding face value. While the advantages of TIP are clear in an inflationary or even hyperinflationary environment, it does have some drawbacks that a number of astute investors have discovered. First, there are inherent conflicts of interest in the adjustment of principal values on TIPS. As one writer points out, the biggest risk with TIPS (and therefore with TIP) is that the creditor is the one calculating the CPI. Although difficult to confirm and obviously never admitted, it is widely believed that the U.S. government has been fudging CPI figures for some time. The incentive to do so in enormous: low rates will keep borrowing costs low, stimulate growth, and reduce interest expense on inflation-protected securities issued by the government. Estimates for the “fudge factor” are all over the board, going as high as 3%. Moreover, some believe that the understatement of true CPI is worst during periods of high inflation, meaning that TIPS let investors down just when they are needed the most.
For investors worried that the massive weight of the stimulus packages and various bailouts have taken the “risk-free” out of risk-free Treasuries, the SPDR DB International Government Inflation Protected Bond ETF (WIP). WIP tracks the performance of the DB Global Government ex-U.S. Inflation-Linked Bond Index, holding government debt that pays interest and principal in the currency of the issuer. WIP is fairly well diversified, holding government debt from 18 countries. The U.K. (19.3%), France (19.0%), Canada (5.3%), Japan (5.0%), and Israel (4.9%) account for the five largest holdings.
So the advantages of WIP over its U.S. peer are relatively straightforward. It is diversified across a number of countries, meaning that it is not overly reliant upon the continued stability or credit quality of any particular government. In addition, while there is little hard evidence to support such a claim, European governments are likely to be more “honest” in their calculations of inflation, due to the fact that they are subject to scrutiny from the European Union.
The obvious issue with WIP is that its underlying securities make interest payments in foreign currencies, meaning that U.S. investors are subjected to an additional risk factor. If the dollar strengthens, current returns from WIP will be diminished in dollar terms, and vice versa. While WIP’s current dividend payout is about 80 basis points higher than TIP’s, it also has a much higher expense ratio (0.50% for WIP compared to 0.20% for TIP).
In addition, both TIP and WIP are plagued by some drawbacks on the taxation front – namely that investors pay taxes on the accretion resulting from inflation.
Disclosure: No positions at time of writing.