Actual panic about inflation seems to be spiraling upward. But investments that will try to protect us from the ravages of inflation seem to be getting cheaper.
Weird, right? Only on Wall Street.
But this is good news for retirees, who stand more to lose from inflation than pretty much anyone else.
(You may have noticed that this year’s “cost of living adjustment” to your Social Security checks, announced with so much fanfare last fall, is already a bust. Even by February official inflation was a third higher than the COLA, and the Cleveland Fed reckons inflation is now running even faster, at 8.5%. Oh, yeah, and these are only the official inflation rate.)
Long-term inflation protected Treasury bonds have plunged in price since the start of the year, despite the official state of National Freak Out over rocketing prices at the supermarket and the gas pumps. And a couple of inflation-protection mutual funds favored by Bill Gates are even cheaper than that.
(If you’re under 40, Bill Gates is some old guy who used to be richer than Elon Musk and Jeff Bezos.)
The PIMCO 15+ U.S. TIPS ETF
which tracks long-term inflation-protected Treasury bonds, is 15% cheaper than it was on Jan. 1, and TIPS bonds from Uncle Sam are now guaranteeing to protect your purchasing power — plus 0.2% a year — all the way through 2052. Such bonds have a positive “real” yield, meaning a yielding on top of inflation, for maturities longer than about 20 years.
Three months ago, when people were much less alarmed about inflation, long-term TIPS bonds were so overpriced that they were actually guaranteeing a total 10% loss in your purchasing power over 30 years—and that was measured using the official inflation rate.
Meanwhile the Western Asset Inflation-Linked Opportunities and Income Fund
a regulated U.S. mutual fund that invests in inflation-protected bonds and related assets, is also on sale and is currently selling at 90 cents on the dollar. WIW is what’s known as a “closed-end” mutual fund. That means even though it is a mutual fund, like the familiar names from companies such as Vanguard or American Funds, you invest by purchasing shares in the fund on the stock market, as you would with a stock like Apple
(WIW is run by fund company Franklin Templeton.)
As there are only a limited number of fund shares in circulation, the share price can move independently to the value of the fund’s investments. So right now the fund has about $13 per share in bonds and other assets, but the shares are trading around $11.60.
A similar fund (also run by Franklin Templeton), Western Asset Inflation-Linked Income
is trading at 91 cents on the dollar.
Bill Gates’s personal investment vehicle Cascade Investments owned more than 20% of the shares in both funds at the last count, according to public filings.
I spoke to Chris Larsen, a senior product manager at Franklin Templeton and in-house expert on the two funds, to understand them a bit more. Both use leverage to increase the size of the fund, much like homeowners take out a mortgage so you can buy a bigger home. For both funds the current loan-to-value is just over 30%.
This leverage, taken at short-term interest rates, has been a terrific deal while interest rates have been so low. Last year they paid about 0.2% — really—on the debt. If the money markets today are right, short-term interest rates in the next year or two will rise to about 2% or more. That could take a big chunk out of the fund’s returns.
But…if the Fed hikes rates, it will presumably be because inflation isn’t under control. If that happens, we may see the value of these fund’s bonds go up sharply too because there will presumably be a lot more demand for inflation protection. Meanwhile we would probably see the fund’s share price rise even further than that, because I suspect if there is a full-scale inflation panic the market won’t still be selling off shares in inflation-protected bond funds at 90 cents on the dollar.
On the other hand, if inflation fears tumble again—if today’s inflation spike turns into tomorrow’s bust—these funds could still be OK: Their short-term interest costs will stay low, and bonds—all bonds—will come back into fashion. And there’s that hefty discount. WIA currently pays out 4.1% of the share price per year in dividends, and WIW 5%.
Larsen tells me that the fund managers aren’t wedded to the amount of leverage, either. If short-term interest costs rise too much, and cease to benefit the fund investors, the company will simply borrow much less. “We’ll keep that leverage on as long as we have a positive “carry,”” he tells me, meaning as long as the return from the investments is greater than the cost of the debt. “The team does adjust the leverage,” Larsen adds. “It’s not “set it (and) forget.””
Incidentally, both funds have expense rates of about 0.7% to 0.8%. Even after accounting for fees, both have outperformed plain vanilla TIPS funds over 5 and 10 years, in part because of the leverage. They also hold assets other than TIPS, such as corporate and emerging market bonds. WIW is supposedly the slightly “riskier” fund of the two, and invests a bit more in things like emerging market bonds, which tend be more volatile.
You pays your money and takes your choice, as they say. Or one can buy unleveraged long-term TIPS bonds.
What is the actual outlook for inflation? Well, the latest numbers show the bond market is getting less concerned than it was a few weeks ago: It now expects inflation to average 3.26% a year over the next 5 years, down from a forecast of 3.6% just a few weeks ago. We shall see.
Once upon a time, over a decade ago, TIPS bonds paid guaranteed interest rates of 2% a year or more above the rate of inflation. By those standards today’s rates are dismal. But what really matters for investors is how they are going to look over the years or even decades ahead.
Veteran money manager Jonathan Ruffer remembers the double-digit inflation of the 1970s, which was even worse in his native Britain than it was here. At the time he was a young money manager in London. He writes: “I remember a colleague in the fund management company Dunbar Group, where I worked at the time, losing his temper with a client who pointed out that she had suffered a real loss when compared with inflation. The client was told she was seeking after a ridiculous aspiration.” (Italics mine.)
Back then investors, Ruffer says, “appeared to be defenceless from inflation.” He fears the same will happen again.
The real inflation issue for retirees isn’t the forecast but the risk. And that’s where things like inflation-protected bonds come in useful.