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msnbc.com
updated 6/22/2006 12:15:24 PM ET 2006-06-22T16:15:24

With Federal Reserve officials talking about getting tough on inflation in the face of their seventeenth consecutive interest rate hike, should individuals be concerned?

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“Yes, clearly,” says Brent R. Harris, managing director at PIMCO, one of the world’s largest fixed-income fund managers.  “The government promises underlying the Social Security and Medicare programs, not to mention other entitlement programs, creates a twenty-to-thirty year period of risk — the risk of deflating our currency and increasing our rate of inflation.”

At Charles Schwab the inflation outlook is less intense but not completely reassuring: “We do not think investors should be overly concerned about inflation,” says Brad Sorensen, senior sector analyst in the firm’s Denver office. “We think the greater risk is global economic slowing.” And while he is not looking for inflation to rise much higher, Sorensen does think it will periodically flare, as it is currently doing, in coming years, causing enough concern for some defensive action in the form of inflationary hedging.

So how does individual protect his savings and investments from inflation? Investing in gold has been seen as a good inflation hedge, and banks and brokerages offer a number of instruments that track the price of gold without actually having to hold bullion or gold coins. But since factors beyond just inflation can affect the price of gold, other inflation-fighting investment options for investors can include commodities-based mutual funds and government bonds.

Gold's allure as inflation hedge
"Many people view gold as insurance against inflation and unstable political situations,” says Frank Trotter, president of EverBank, a Florida-based bank with a national online presence.  His bank has developed a certificate of deposit linked to the price movement in gold bullion for use as an inflation hedge. 

Its new MarketSafe Gold Certificate of Deposit is FDIC-insured and, like any CD, guarantees the return of principal.  It does not, however, guarantee there will be any return earned on that principal during the life of the CD, nor does it pay any interest.

Like investments in gold coins or bullion, the EverBank product captures movements in the spot price of the bullion. There is no guarantee of upward movement nor that it will match or exceed returns on other investments.

However as a hedge, EverBank’s CD does address some of the problems associated with holding the metal directly.  Chief among them is the expense and difficulty in storing bullion or even coins; the risk of theft; and the dollar commitment needed to own metal.  With minimum deposits of $1,500, the EverBank product offers a low-cost point of entry for speculating on gold without risking one’s original investment. But in exchange for that guarantee is an inability to trade gold during market swings or to liquidate if money is needed.

Another option for owning gold bullion in paper form is the exchange traded fund (ETF), streetTRACKS Gold Shares.  As a trust it acts as a repository for bullion. Unlike the CD, the share price may fluctuate below an investor’s cost, but being publicly traded it offers instant liquidity.

“It is a very convenient and cost effective way to participate directly in the price of gold,” says Harris.

Another opportunity for hedging against inflation is through the purchase of gold mining stocks. Some of these companies do pay dividends and offer price appreciation. But, says Harris, “these stocks will not act one-for-one with moves in the price of the metal because the companies themselves have operating issues that come into play. Also, the companies hedge against the price volatility, so investors may not achieve their objective.  But during bull markets in gold, mining stocks do appreciate,” he adds. 

“Gold is certainly a good hedge if people are concerned about inflation taking hold. However, we are cautioning clients against jumping in at these levels,” says Sorensen.  The problem with gold is that it has soared recently for a number of reasons — industrial and jewelry demand along with pure speculation. This is why gold is an imperfect hedge against inflation: Its price can rise with or without inflation.

Another inflation-protecting option is to invest in a broader basket of diversified commodity index-linked securities.  Such "baskets" of securities would include gold, but also provide exposure to the commodities contributing to the inflation like crude oil, natural gas, soybeans, cotton, and even silver. 

“This provides more balanced protection against price risks,” says Harris, whose firm oversees one of the biggest of these baskets, the PIMCO CommodityRealReturn Strategy Fund. Additionally, several ETFs, which create similar index-linked exposure have recently debuted.  These include Deutsche Bank’s DB Commodity Index Tracking Fund and Barclays Bank’s iPath series of exchange traded notes.

EverBank also offers a CD tied to various currencies from commodity-dependent countries for those wishing to take the guaranteed principal approach. These CDs, however, require minimum deposits of $20,000.

Bonds seen as the best inflation hedge
While such commodity baskets offer inflation protection when commodities are in bull market mode, the most direct way of addressing inflationary concerns is by buying inflation-indexed bonds.

The U.S. Treasury issues two types of bonds directly linked to inflation.  Its Series I Savings Bonds may be purchased at no cost through TreasuryDirect, or at any bank, in denominations as low as $25 when purchased online.  They pay earnings on a deferred basis so they are not taxable until they are cashed in, and at that point they remain free of state income taxes. 

Also available through TreasuryDirect are Treasury Inflation-Protected Securities  (TIPS).  There are also a number of mutual funds that own TIPS — easily identified by the words ‘inflation’ or ‘real return’ in their titles.  There is also an ETF, the iShares Lehman TIPS Fund.  The advantage of these funds is that they offer greater liquidity and greater diversification in terms of maturities.

The true attraction of TIPS is that they offer a direct hedge to inflation with far less volatility than gold or commodities.  That they are direct obligations of the U.S. government makes them the perfect fit for risk-adverse investors.

Harris offers one other inflation-sensitive asset appropriate for individuals — it is one hat many already own — real estate. This is why regardless of whether or not individuals choose to add inflation protection to their investment portfolio — or how they choose to do it — they need not go to extremes. Their largest investment, their homes, already gives them exposure to an inflation-sensitive investment.  This is also why Harris, like other advisors, recommends no more than 5-to-20 percent of a securities portfolio be devoted to inflation-protecting investments — a little bit can go along way toward insuring that invested assets retain their purchasing power over time.

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