Even though the S&P 500 was up 16 percent and 2012 delivered some of the best equity returns in more than a decade, investors remain skittish about stock-based mutual funds. Morningstar reports significant inflows for virtually every bond fund category in 2012 while for the fourth consecutive year stock fund outflows continued, totaling $34 billion last year.
It is quite understandable that the intense volatility of the equity markets has investors looking for protection from investment risk. Among the vehicles that have found favor with some advisors and their clients are Treasury Inflation Protected Securities (TIPS). These instruments are marketable securities designed to provide protection against inflation whose principal is adjusted according to changes in the Consumer Price Index (CPI). In an inflationary environment the principal increases and in deflation it decreases.
Investors saving for retirement certainly want to protect their investments from eroding in value due to inflation, but it is important that they make an informed choice when arriving at a solution and understand the risks they are taking on. What many fail to realize is that TIPS market prices move substantially along with changes in real interest rates, which means that the share prices of mutual funds investing in TIPS can vary significantly over the short term.
TIPS can also be more expensive than they may initially appear. Currently, for a 5-Year TIPS the yield-to-maturity is -1.47 percent and the 5-year break even inflation rate is 2.09 percent. Essentially, an investor would be accepting a return of 1.47 percent below the rate of inflation over the next 5 years. If inflation over the next 5 years is 2.09 percent, then strictly on a yield basis, an investor would achieve a 0.62 percent return (this figure does not account for any price appreciation or depreciation). If inflation is greater than 2.09 percent, then the investor will achieve a greater return (before any price movement).
If the economy continues to be sluggish, and all indications are that it will, there's not a lot of potential return here. The result would be even worse in a deflationary environment. If an investor buys a seasoned issue, there could be principal erosion in addition to income risk and that doesn't appear to have been factored in by many investors.
Advisors should also be aware that if their clients own indexed aggregated bond products, they already have Treasuries in their portfolios. Treasury securities have traditionally been a safe haven, but there are numerous potential event risks that we face including the budget deficit, the unresolved fiscal cliff and the ongoing debt ceiling drama.
Another problem with investments in TIPS is that they are tied to the CPI-U, which is the Consumer Price Index for All Urban Consumers -- a figure has been kept artificially low. Consumers know that the prices of pork, chicken and beef are all considerably above what they were three years ago, but that hasn't been reflected in the CPI. The government has a vested interest in keeping that number down since increases in Social Security and other benefit payments are tied to it. An accurate reflection of the rate of inflation would mean hundreds of millions of dollars in additional entitlement payments.
For those concerned about inflation, a better option than TIPS might be to choose investments that offer tangible cash flow, such as infrastructure, timber, agriculture and other sectors with ties to essential services. So, instead of taking government counterparty risk, the investor is making a bet on companies that have cash flow on a daily, weekly and monthly basis that is predicated upon essential items like food and energy bills.
Whether the economy is booming or in a recession or depression, people need water, they need electricity and they have to eat. Infrastructure and essential services investments may not be particularly glamorous, but they provide capital appreciation coupled with a high income component. They are a perfect counterpoint or counterbalance to fixed income real asset investing or real return bonds (TIPS).
Inflation-linked assets such as agribusiness, timber and infrastructure can produce a higher return when inflation rises. They also provide unique attributes that contribute to an investment portfolio's overall diversification and income needs while providing a much needed inflation hedge.
Advisors seek to position their client's portfolios to realize the highest expected return while prudently managing risk. My research leads me to believe that investing in agribusiness, timber and infrastructure on a global basis is likely to produce a significantly higher expected return than any TIPS. There appears to be much more downside risk in TIPS in terms of total return. They are so expensive that the potential inflation properties may be muted.
On the other hand, global timber securities currently yield a return of about 2 percent. An increase in timber demand combined with resource scarcity and the potential for inflation indicates this as a relatively good bet in terms of equity investment.
Global infrastructure securities offer a yield of approximately 4 percent as well as inflation adjusted cash flows. Global agribusiness securities yield about 1.5 percent, which should be considered along with rapidly rising food price inflation and scarcity. This gives some companies in this sector a great deal of pricing power, resulting in attractive opportunities for returns.
For long-term planning, it is important that advisors look for diversified inflation hedging assets outside of TIPS, commodities and managed futures. In order to protect retirees from significant erosion in purchasing power, it is useful to include investments that mitigate the impact of inflation. A global investment strategy that includes allocations to agribusiness, timber and infrastructure can help achieve that goal.
Michael D. Underhill is Chief Investment Officer of Capital Innovations, a boutique investment manager specializing in listed real asset strategies.