Is inflation a risk?
Three ways
to protect against inflation
There has
been lots of talk of the monetary and fiscal stimulus used by G7 central banks
to support the economy in this very uncertain time. While many view this as a
positive move to prevent a deep recession shorter-term, some have expressed
concern over the potential inflationary impact of this stimuli. How can we
worry about inflation when all we’re hearing about is the dreaded ‘R-word’
(i.e. recession)? Well, because recessions typically don’t last a very long
time and by the time all the monetary and fiscal policies have kicked into high
gear to push inflation up, it’s too late to prevent it. Personally, I don’t
think inflation is a big risk, but it’s definitely a very real risk.
Before
proceeding, a brief lesson on what these policies are all about may be helpful.
Governments have two general types of tools at their disposal when it comes to
“managing the economy” – fiscal and monetary policies.
Fiscal
policies refer to government spending practices. The economic slowdown
resulting from the WTC attacks prompted the U.S. government to approve bailout
packages for certain industries. The U.S. senate has also approved $40 billion
in spending to finance this “war on terrorism” that is building by the day.
Further, all the talk of increased security in airports, airplanes, and
government buildings will structurally change the workforce. All of a sudden,
there will be a certain number of permanent jobs in this area that previously
did not exist. While that puts money in more people’s pockets, it also
increases the costs of travel – which affects leisure costs for many, and
really can drive up business costs for those industries/companies with a heavy
reliance on efficient air and cross-border travel. Rising operating costs often
trickle down, to some degree, to the end consumer.
At the core
of monetary policy is the government’s influence over interest rates. Interest
rates, across the globe, have been lowered substantially both pre- and post-
attack. When interest rates are lowered, it becomes more attractive for people
to borrow money – to buy cars, real estate, make business investments, etc.
That buying spurs demand in the industries where spending is taking place.
In both
cases, it takes some time (i.e. six to eight months) for policy changes to
“ripple through” the whole economy and have a real impact, which is why it’s
difficult to see through today’s murky economic picture. However, for those
thinking inflation might rear its head, there are investments that offer some
protection.
Rising
inflation typically brings with it rising interest rates. As interest rates
rise, bond prices get hammered, but money market instruments – like treasury
bills and money market funds – benefit from rising rates. Since treasury bills
(t-bills) are usually very short-term in nature, investors are constantly
“turning over” their t-bills at higher rates. This allows investors to ride the
wave in periods of rising interest rates. Money market funds provide the same
benefit since they’re usually filled with t-bills and other similar money
market instruments.
This
doesn’t include GICs. While they’re usually included in the “cash” grouping of
investments, the locked-in nature of GICs prohibits investors from benefiting
from rising rates.
Last week,
we talked about hard assets – and gold in particular – as a good way to
maintain stability in times of market crisis. However, if inflation is the
concern, just about any hard asset should benefit – real estate, gold, other
precious metals, energy and other natural resources – though real estate is the
most sensitive of these to interest rates.
One way to
get broad exposure to many of these areas through a mutual fund is the category
known as “high income balanced” funds. Holding a mixture of royalty trusts
(i.e. energy), real estate investment trusts (a.k.a. REITs), and other income
trusts in diversified industries, these funds have potential to provide some
protection against inflation without taking very high risks. My favourites in
this category are Saxon High Income (http://stocks.myto.com/mutualfund/FundList.asp?MasterKey=195&FundKey=11846),
Bissett Income (http://stocks.myto.com/mutualfund/FundList.asp?MasterKey=207&FundKey=10440),
and CI Signature High Income (http://stocks.myto.com/mutualfund/FundList.asp?MasterKey=128&FundKey=10580).
Otherwise,
take a look at the precious metals fund recommendations in last week’s column (http://www2.myto.com/money/tidd_fs.cfm?source_id=&id=1002182).
Probably
the safest way to combat inflation is the use of real return bonds. RRBs were
innovated by the Bank of Canada more than ten years ago. In a nutshell, both
the maturity (a.k.a. par) value and the semi-annual interest payments rise with
the consumer price index (CPI). The bonds can be purchased through stock
brokerage firms and are eligible for self-directed RRSPs and RRIFs. Those more
detail-oriented readers who want more information can visit the Bank of
Canada’s website for this nine-page document (http://www.bankofcanada.ca/en/pdf/real_return_eng.pdf)
on real return bonds.
Investors
who want this type of protection but feel intimidated or uncomfortable buying
investments through a brokerage can take a look at the TD Real Return Bond fund
(http://stocks.myto.com/mutualfund/FundList.asp?MasterKey=184&FundKey=13769).
With a management expense ratio of 1.64 per cent, the fees are a bit steep but
this is the only way to buy RRBs through an investment fund.
In either
case, investors may want to consider RRBs for up to 1/3 of their bond
components. The exact amount each investor should hold is a personal decision
but this should provide a general guideline.
So
attractive are the features of RRBs that our neighbours to the south developed
their own version, known as TIPS (treasury inflation protected securities), but
did us one better. They developed something known as the I-bond. Essentially,
it’s the same thing as RRBs and TIPS, but with tax-deferral power. The I-bond
concept has a very natural appeal – guaranteed protection against inflation,
security of the government, and the deferral of income tax.
A group of
Canadian investors is so passionate about the potential benefits of I-bonds,
that they’ve started an on-line campaign to bring the tax-deferred I-bond
concept to Canada. A website has been set up at http://canadianinvestor.tripod.com/
to inform Canadians on the benefits of I-bonds and they’ve even got a “cyber
petition” that can both be viewed and signed.
The
benefits that a vehicle like the I-bond can bring to individual retirement
plans is substantial and has been supported in academic research over the past
few years. Check out the website and sign the petition if you think this is a
good idea. I’d certainly be in favour of this concept, so I signed the petition
myself a couple of months ago.
It’s not
known if the Minister of Finance would support a Canadian I-bond, but this is a
democracy, so we should make our opinions known to lawmakers.
I don’t
want to scare anybody into thinking inflation will soon follow this recession
that seems to be forming. We have enough bad news these days. However, protecting
your portfolio from the effects of inflation should be a longer-term strategy
rather than a shorter-term speculative play. Investors should get used to
thinking of investment returns in the context of what we call “real returns” –
that is the return net of inflation – because that’s what really counts.
My
preferred inflation-fighter is the RRB. Whether you hold it in the form of
actual bonds or the mutual fund, it should bring valuable stability and
diversification properties to portfolios. And if you want our government to
take this concept one step further, voice your support for the I-bond campaign.
Dan Hallett, B.Comm.,
CFP is Senior Investment Analyst with Sterling Mutuals Inc. He can be reached
at dhallett@sterlingmutuals.com Sterling Mutuals Inc. is registered as a
mutual fund dealer in Ontario, British Columbia, and Manitoba.