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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 stimulus. 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.

Monetary and fiscal stimuli

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.

Cash is king

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.

Hard Assets

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, Bissett Income, and CI Signature High Income.

Otherwise, take a look at the precious metals fund recommendations in last week's column.

Real Return Bonds (RRBs)

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 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 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 stimulus. 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.

Monetary and fiscal stimuli

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.

Cash is king

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.

Hard Assets

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, Bissett Income, and CI Signature High Income.

Otherwise, take a look at the precious metals fund recommendations in last week's column.

Real Return Bonds (RRBs)

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 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. 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.

I - Bond Campaign

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 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.

Recommendation

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, CFA, CFP is the President of Dan Hallett & Associates Inc. in Windsor Ontario. DH&A is registered as Investment Counsel in Ontario and provides independent investment research to financial advisors. He can be reached at dha@danhallett.com
 
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