Hedging inflation using income funds

There is more than one way to generate income

Income generation is a primary focus for many of today’s investors and there is a myriad of instruments handy for this purpose.

What income focused investors tend to have in common, however, is an unbounded time horizon: they generally don’t know for how long they’ll need the income. This requires an informed and proactive strategy for addressing the #1 enemy of fixed income streams over the long term: inflation.

Inflation: Back

From the Grave?

Inflation? Did you think it was dead? It seems so — “slack” remains in the economy in the form of excess supply, a lack of wage price pressures, etc. — but does even the Bank of Canada’s two per cent target qualify as “dead”?

A two per cent loss in purchasing power every year amounts to a real economic loss to nominal guarantees and fixed cash flows of 22 per cent after only 10 years, compounded annually.

And that’s only core inflation. Economists would rather we not think about the bite headline inflation has taken out of our real-world pocketbooks. This is why it is important that investors think strategically and long-term when it comes to protecting their investment dollars.

Defending the

Threat

Accepted wisdom suggests that investors can defend against inflation in several ways: inflation-linked securities, cash/ short duration, equities (especially those with pricing power), commodities, gold, and commercial property. Our purpose is not to challenge this wisdom, but to propose ways to take advantage of these (imperfect) natural hedges without giving up the income stream you depend on.

Strategy #1: Stay

Short

Real return bond funds would seem the natural choice for clients seeking shelter from the cold hand of inflation via a fixed income product.

The challenges in this space are: a) issuance (supply) in Canada is poor, such that prices tend to rise out of reach quickly with just a sniff of demand, and b) terms are invariably long, subjecting the bonds to undesirable rate volatility. An attractive alternative for suitable investors is Claymore Short Duration High Income ETF.

This product invests in higher-yielding (but not necessarily below investment grade) U.S. bonds, and keeps the portfolio’s average duration at one year or below. It is an actively managed portfolio run by Claymore’s U.S. parent, Guggenheim Partners. It is somewhat prone to a credit freeze, and it hedges rising rates rather than inflation per se, but it has good liquidity, an attractive underlying yield as of April 5, 2011, and is currency-neutral.

Strategy #2:

Dividend-Payers

with Pricing

Power

Equities are not known for their performance in inflationary environments, but dividend payers give you the benefit of cash flow while you wait.

Also, companies with pricing power can pass on inflation’s price effects to their clients more quickly than others, helping them withstand inflation pressures more effectively.

Infrastructure stocks in particular feature high yields due to their solid cash flows, and are able to re-price their products quickly and easily, without much hit to demand. Note however that they can be sensitive to unexpected rate increases.

Strategy #3:

Resource

Companies with

Yields

The best hedge against inflation, according to the literature, is commodities, at least in the short term. Unfortunately, commodities don’t generate cash. Dividend-generative equities in the commodity sectors can act as decent proxies, however, and the smaller capitalization market in Canada is dominated by such companies.

Hedge Your Cash

Flow

The chief enemy of any long-term income strategy is inflation, and whether you believe it has the potential to rise in the future or not, it is gnawing at your purchasing power as we speak. Guaranteed products, such as Principal-Protected Notes (PPNs) and GICs are particularly exposed. A well-developed defensive strategy can help sustain a portfolio’s value while keeping your cash flow safe from inflation’s grip. Please feel free to call or e-mail for more information, or visit my website at www.jimgrant.ca.

Jim Grant, CFP (Certified Financial Planner) is a Financial Advisor with Raymond James Ltd (RJL). This article is for information only.  Securities are offered through Raymond James Ltd., member CIPF. Insurance and estate planning offered through Raymond James Financial Planning Ltd., not member CIPF. For more information feel free to call Jim at (250) 594-1100, or e-mail at jim.grant@raymondjames.ca. and/or visit www.jimgrant.ca.

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