EnvisionCap.com: Forbes Article - How to Fight Inflation

How to Fight Inflation

Marilyn Cohen, Forbes Magazine, 1.12.04

Think inflation is headed upward? TIPS aren't the only way to tackle this problem; corporate inflation-adjusted bonds are a new answer. They adjust more often than TIPS, for one thing.

Methinks the Federal Reserve doth protest too much. We hear a chorus of Federal Reserve bank presidents, including those in Richmond,St.Louis and Dallas, singing the same melodic refrain that interest rates can be kept low "well beyond March." What about the market, gentlemen? You--the Fed, that is--can control only short-term interest rates. The market is master over everything else. A buoyant economy, a declining dollar, firming employment and protectionist drumbeats mean that, despite all you can do to keep short-term rates low, long-term interest rates will move higher.

Coming right alongside this rise in rates will be a rise in inflation. It's hard for a bond investor to hedge away the risk that real interest rates will climb as the economy heats up. But it's not at all hard to hedge away the inflation component of rate rises. Just buy the Treasury Inflation Protected Securities, or TIPS. Now there is another way to hedge the Consumer Price Index: inflation-linked corporate bonds. I think they are even better than the Treasury variety.

The corporate version does much better than TIPS for those who seek income now, an important goal for many bond investors. Both kinds of debt security are adjusted according to the change in the CPI. The difference is how often they are adjusted and how quickly the adjustment turns into cash for the investor.

In the Treasury system the bond's principal is adjusted semiannually for changes in the CPI. If your principal starts out at $1,000 and inflation is 5%, your principal goes to $1,050 after a year. The adjusted principal is used to calculate interest payments. Say the coupon is 2%. The interest starts out at a rate of $20 (annualized) but would go to an annual rate of $21 a year later. You owe immediate tax on both the interest payments and the principal adjustments, even though the latter turn into cash only when the bond matures.

The corporates, available from Household Finance, Sallie Mae and Fidelity Investments, pay monthly interest. And they pay out in cash both the (real) coupons and the principal adjustments; at maturity the principal is the same $1,000 you invested. Corporate bonds, but not Treasurys, are subject to state income tax.

Yields on corporate inflation-adjusted bonds are 0.4 percentage points over comparable Treasurys for an A-rated bond. These spreads could widen a bit as the economy picks up steam, but the risk is small enough that I would not wait to go into the corporate bonds.

Household Finance, now a subsidiary of the huge bank HSBC, issued inflation-adjusted bonds in November carrying an initial coupon of 4.49% and maturing Nov. 10, 2013. The 4.49% consists of two pieces. One is an inflation adjustment of 2.32%, equal to the then-trailing 12-month increase in the cost of living. The other component is the real coupon, which stays constant at 2.17%. This is a noncallable bond. At the time of this new issue, conventional ten-year noncallable Household Finance bonds were yielding 4.89%, or 0.4 points more than the inflation-linked kind. The reason: The holder of a conventional bond is taking the risk of getting chewed up by unanticipated inflation. The holder of the 2.17% self-adjusting bond is not.

If inflation is destined to increase over the next ten years, the 2.17% bonds will rapidly outyield their traditional fixed-coupon counterparts and that 0.4-point shortfall will be a memory. If, on the other hand, a Japanese-style deflationary cloud settles on the landscape, the conventional bonds would do much better.

What happens to CPI-linked bonds during deflation? Bad things. The Treasury bond can have a downward adjustment in the principal, but not below its starting value. Thus if inflation were 5% the first year and negative 6% the next, the principal would go from $1,000 to $1,050 and then back to $1,000. You always get the coupon. In my hypothetical, your total nominal return on the TIPS would be a minimum of 2% a year, no matter how bad deflation is.

The corporates do worse during deflation. They can have negative interest adjustments up to the full amount of the real coupon. The Household Finance bond would yield nothing during months when annualizeddeflation was at or above 2.17%. If deflation kept up at that rate for the whole decade, the Household holder would get no interest return.

I am a moderate Cassandra on the inflation front. I see a climb above the recent 1.8% level but not a 1970s-style double-digit horror show. More like somewhere around 3.5% annually. That's enough to make CPI-indexed bonds very attractive.

Marilyn Cohen is president of Envision Capital Management®, Inc., a Los Angeles fixed-income money manager and author of The Bond Bible. Find past columns at www.forbes.com/cohen.