TIPS won’t do it. If you want to come out ahead, you have to take some risks.
The run-up in prices that the authorities were calling “transitory” seems to be sticking around for a while: 6.2% over the 12 months to October. What are you going to do about it?
The obvious and safe choice is a portfolio of Treasury Inflation Protected Securities. But everyone is buying those bonds, driving up their price and giving them a negative real return. Hold one to maturity and you are guaranteed to be poorer at the end.
If you want any hope of coming out ahead of the Consumer Price Index, you have to take some risks. Herewith, three ways to add an inflation hedge to a portfolio. They are all much more volatile than TIPS. But they give you a fighting chance of beating inflation.
1. Bond puts
Inflation, if it persists, will drive up interest rates. That would kill those bonds you have in your retirement account. Consider purchasing an insurance policy. The Simplify Interest Rate Hedge ETF supplies that insurance.
This novel exchange-traded fund, released for public consumption six months ago, has, besides a cash position, just two holdings. One, representing $25 of the $40 net asset value per share, is a very safe Treasury bond due in five years. The other, representing $15 of value, is a put option. The option is an indirect bet against $800 worth of long-term bonds.
The option is a long shot. When it matures in May 2028, it has value only if 20-year Treasuries (the usual variety, without inflation protection) are then yielding more than 4.25%. Since such T bonds now yield 2%, the bond market would have to go into a pretty savage correction, taking rates up 2.25 percentage points, for your put option to be worth anything at all in 2028.
You can’t ring up your broker and buy a put like this at some options exchange. Simplify buys the options over the counter from banks. (The puts are keyed to the so-called 20-year swap rate, which tracks Treasury yields pretty tightly.) With $125 million of investors’ money in hand, the fund owns puts on $2.5 billion of bonds. The fund (ticker: PFIX) has a 0.5% annual expense burden.
Harley Bassman, an executive at Simplify Asset Management who helped concoct the option strategy, notes that the put is a wager on nominal interest rates, not on inflation. Inflation and nominal rates are closely connected, as an economist famously noted a century ago, but they do not march in lockstep.
Conceivably, we could have stiff inflation for a few years while bond investors sit still for that crummy 2% yield on long Treasuries. Such an outcome would mean that real rates sink even farther below zero than they are now. In that case, the put options fail to pay off, even as your groceries bills shoot up.
But the rate equation could just as easily go the other way. In this scenario, savers tire of lending money to the U.S. government at 2% when that government is inflating away their dollars at 4% or 6%. They stop buying so eagerly, and the rate on the inflation-adjusted 20-year T bond climbs from its present value of -0.7% into positive territory. If the real rate hits 1% at the same time that expected inflation is 4%, the rate on long Treasuries lacking inflation adjustments goes to 5%. Your puts would deliver a nice gain, enough to cover grocery bills or some of the damage done by rising rates to the bonds in your retirement portfolio.
Bassman estimates that if nominal rates climb by 2 percentage points over the next two years, the share value of PFIX should more than double. Although the puts would at that point still be out of the money, they would be quite valuable because they would have five years of life remaining in a very volatile bond market. At the seven-year mark, however, future volatility becomes irrelevant and the puts are worth money only to the extent long-term rates exceed 4.25%.
You could hedge $1 million of long-term bonds by buying 1,250 shares of PFIX for $50,000. You’d have fire insurance, albeit with a large deductible. (Remember that bond yields have to move quite a long way before the puts kick in.) If we get another 1970s-style bond crash, the insurance will reimburse you for much of your losses.
If the puts expire worthless, a distinct possibility, you’ll be out $20,000.
Traditional inflation hedge: gold. It’s an imperfect hedge, with long stretches of disappointing returns, but it seems to work over the long pull. In the past century the price of gold has comfortably outpaced the CPI.
You could just buy a bullion fund. But there’s an easy way to leverage the bet. Instead of buying gold, buy shares of gold producers.
For the arithmetic we’ll turn to Joseph Foster, a geologic engineer turned portfolio manager at Van Eck Associates. That firm has, for half a century, offered tools to fight inflation, initially precious metals funds. The diverse line-up now includes cryptocurrency plays.
Barrick Gold Corp. will, Foster projects, produce 4.5 million troy ounces of gold this year at a cost averaging $700. That’s the marginal cost of moving metal from the earth into an ingot; it excludes the sunk cost of developing the mines. When gold is at $1,860, Barrick’s gross profit is $1,160 an ounce. If gold’s price rises 10% to $2,050, the profit rises 17%.
Prices of gold producer shares track profits, although not in any precise fashion. “The long history of gold mining stocks is close to 2 times leverage to the price of gold,” Foster says.
For still more leverage, skip blue chips like Barrick and Newmont Corp. in favor of smaller producers with higher costs. Argonaut Gold, traded on the Toronto exchange, produces 222,000 ounces a year at a cash cost of $1,000, Foster says. A 10% move in bullion would probably do more for Argonaut than for Barrick.
The Van Eck Junior Gold Miners ETF has $5 billion invested in 100 companies like Argonaut. The annual expense rate is 0.52%.
A classic way to keep up with the cost of living is to own rental property for which the rent is frequently adjusted. That’s the argument for buying shares of real estate investment trusts. Reits, though, are quite expensive in comparison to the income they distribute. Another problem, made visible in the pandemic: It’s not easy to keep office buildings and malls occupied.
For an alternative stream of rental income, consider firms that collect fees for handling fossil fuel, in effect earning rent on pipes, barges and compressors. Some are organized as partnerships, some as corporations. They go under the category “midstream energy.” They pay nice dividends. Examples: Oneok, Targa Resources, Cheniere Energy.
Simon Lack, a Westfield, N.J. money manager who specializes in portfolios of energy stocks and other inflation-resistant assets, says the revenue of midstream companies is “reasonably well protected from inflation” by dint of contracts that either have cost-of-living adjustments or are geared to the price of fuel.
My favorite midstream ETF is Tortoise North American Pipeline (TPYP), with assets of $450 million. It has two virtues not often seen in energy funds: a low expense ratio (0.4% annually) and a portfolio allocated less than 25% to partnerships. Veering over that percentage makes a fund potentially liable for corporate income tax.
Morningstar clocks TPYP’s yield at 4.5% and gives the fund five stars and a gold rating.