Me? Worry About Inflation?

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.

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 [email protected].