From the September 2007 issue of Investment Advisor • Subscribe!

September 1, 2007

Me? Worry About Inflation?

Now may be a good time to raise the inflation issue with clients

January 1, 2006, was an important date in history: Not only did early hip-hop pioneer Grandmaster Flash turn 48 years old, but the first of the baby boomers reached age 60. With this historic event, we believe we will begin to see a change of attitude and focus among the newly retired generation--a shift from wealth creation to wealth preservation.

Preserving wealth may not seem as hard as creating it, but it is tougher than most people would believe. Just look at the Forbes 400 list of the wealthiest Americans. Over the 23 years since its inception, only 11% of the original 400 have managed to remain on the list. Over the years, certain issues have caused an erosion of that wealth, including over concentration, over leverage, and family discord.

These factors may well also affect the wealth preservation of your clients. An even more powerful threat to their wealth preservation may be as simple as "inflation."

I can imagine what you are thinking: "You're kidding, right?" In the past 10 years, inflation has been low and stable. So why bring this subject up now?

It's true that inflation has been restrained--within the Federal Reserve's "comfort range"--and we believe inflation should continue to remain under control in the short term. However, there is no clear-cut argument ruling out an inflation threat in the long term. Although the past may not be an indication of the future, a look at previous U.S. economic conditions shows that inflation can rise suddenly and unexpectedly.

Now may be a good time to have a discussion regarding your clients' expectations about inflation and to suggest specific ways they can protect themselves in case of any sharp accelerations in inflation.

A question that JPMorgan Asset Management has found useful to spark this conversation is: "How much inflation can you stand before putting your long-term goals at risk?"

Are Your Clients Protected?

Traditionally, investors have hedged against inflation by using such alternative investments as real estate or commodities. But as we see a change in baby boomer attitudes toward wealth preservation, clients with a lower risk tolerance or income-oriented goals may find that Treasury Inflation-Protected Securities (TIPS) and the more recent consumer price index (CPI)-related derivatives may be a better fit.

This article will focus on how TIPS, and their synthetic cousins, may help protect the affluent investor against inflation.

TIPS were introduced to the market about 10 years ago with minimal fanfare. Slowly and quietly they have grown in popularity and now represent about 10% of overall Treasury debt. That amount is expected to rise to about 15% over the next several years. This growth has resulted in more liquidity, transparency, and scalability, which has fostered the growth of the derivative markets (i.e., synthetic inflation hedges).

Defining Tips

In the simplest terms, TIPS are a type of Treasury security that offers bond investors protection from inflation by indexing the principal and coupon payment to the U.S. CPI.

For example, if the CPI goes up by 1%, the value of the bond would go up by 1%. Therefore, if we take a $1,000 inflation-indexed bond with a 4% coupon rate and 1% inflation the principal would be increased to $1,010, and the semi-annual interest payment would be $20.20.

In comparison, a normal or "nominal" bond pays its interest on a fixed principal amount, which is repaid at maturity. Inflation is a major risk to a nominal bond holder, since increasing inflation means reduced "purchasing power" in the face of increasing prices.

Thus, because TIPS remove the uncertainty associated with inflation risk, they tend to be less volatile than nominal bonds and generally less volatile than nominal Treasuries. Even so, TIPS are still subject to price fluctuations, which usually occur when real interest rates change. As a result, TIPS' principal value can move up or down with inflation or deflation, respectively. However, for bonds purchased at new issue and held to maturity, TIPS will pay the greater of the inflation-adjusted principal or par.

Normally, bond investors demand an extra "yield premium" or compensation for inflation risk (see Interest Rate Refresher). Since inflation-linked bonds are not exposed to inflation, their yield is lower than normal or nominal bonds.

There is no such thing as a free lunch and the same goes for inflation protection. The cost of this "insurance" is return. Investors forego a small amount of return relative to normal (nominal) Treasury bonds in a majority of periods. In other words, TIPS tend to underperform (relative to nominals) in a majority of months.

A way to describe this situation to your less investment-savvy clients could be something to the effect of "Generally speaking, when people want to protect their situation against a very negative outcome (e.g., fire, death, etc.), they either directly pay a premium or give up some possible benefit."

But the good news is that TIPS can outperform in times of an inflation scare. While inflation scares may be relatively rare, they can lead to a significant outperformance of TIPS over nominal bonds (see table below) at the very time when your clients may need it most.

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If you can help your clients understand this concept, then their expectations will be managed, which is key to their staying committed to an inflation-protection plan. As most financial planners are well aware, the only risk worse than inflation to our clients' success is their own irrational behavior.

To date, the core users of TIPS have been the institutional markets. But with all its benefits, why have individual investors been slow to adopt this strategy? The answer can be summed up in one word (and it's not "plastics" as recommended to Dustin Hoffman in "The Graduate"). The reason is "taxes."

Taxable investors are generally taxed not only on the cash income received from TIPS, but also on the bond's principal accretion. This is analogous to the treatment of zero-coupon bonds, where investors must pay tax on the bond's implied accretion, even though no cash is received prior to sale or maturity. The higher inflation goes, the greater the tax on the inflation component.

In essence, investors pay taxes before they get the cash, the dreaded "phantom income" that is extremely distasteful to most affluent investors.

Using Synthetics

As we stated earlier, the growth of the TIPS market has resulted in more liquidity, transparency and scalability, allowing for the development of a more mature derivatives market (i.e., synthetic inflation hedges) in the past few years. It is now easier and more cost-effective to synthetically "create" a tax-aware inflation protection option for investors than in the past.

As a result, we are seeing the creation of municipal portfolios combined with a sophisticated inflation-protection overlay.

As of this writing, as far as we are aware, affluent investors have access to two basic vehicles for this type of strategy.

  1. Samson Capital Advisors The Tax Efficient Inflation Protection Strategy Partnership (which apparently is closed to new investors at the moment)
  2. JPMorgan Tax Aware Real Return Fund* (see footnote next page for disclosure information)

The underlying sophisticated inflation-protection overlay or "synthetic" of these funds is a swap--where Party A commits to pay Party B a stream of fixed payments and to receive in return a stream of inflation-linked payments.

For example, the approach of the JPMorgan Tax Aware Real Return Fund is to purchase zero-coupon bonds at a fixed rate in exchange for a floating rate that will adjust as changes in the CPI occur. As inflation increases, the Fund should be paid more and, conversely, should be paid less in time of deflation.

The end result is that clients receive tax-free municipal bond income along with an instrument that's adjusting its payout with inflation.

Beware: Only the municipal portion is "tax-free," so the swap is not perfectly tax-efficient. The swap's resulting gain/loss, short or long depending on time held, is considered a capital gain.

I would be remiss if I didn't mention that inflation-linked muni debt does exist. It is still a small sector relative to the entire municipal bond market, meaning that liquidity is limited and there may be problems with access and valuations, which may not make inflation-linked muni debt appropriate for your clients.

As the old saying goes: "The time to buy insurance is when you don't need it." This applies to inflation as well. Get the conversation started with your clients now. Probe them to understand their expectations regarding inflation. Are they concerned? Do they have a low tolerance for "event risk" (i.e., a spike in inflation)?

As you do your client reviews, ensure you make this part of your discussions. In fact, you may want to make this a line item on the agenda.


Susan L. Hirshman, CFP, CPA, CFA, CLU, is a managing director for JPMorgan Asset Management in New York. In that position, she develops strategies to provide wealth solutions to the affluent market. She can be reached at susan.l.hirshman@jpmorgan.com.

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