Can Commodities and TIPS Protect Against Inflation?

Can Commodities and TIPS Protect Against Inflation?

Are commodities the answer to protecting your portfolio against rising prices? And what bonds options are out there to help your income keep pace? Portfolio Manager Charlie Toole discussed defending against inflation in our recent webinar,* Stocks, Bonds and the Fog of War—Our Investment Perspective.

Please enjoy the excerpt below and click here for the full webinar replay to hear more. 

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Charlie Toole:

One of the best strategies to guard against rising inflation is commodities, up nearly 25% so far this year, certainly providing protection against inflation. But before you jump right into the commodities pool, I want to provide two points of caution about investing in them.

First, they’re very volatile. Consider the most popular commodity, which is oil. It has nearly three times the daily volatility that the stock market does. Why is that important? Well, that means bigger price movements on the way up and on the way down. Historically, after big price run-ups, commodities usually have big drops.

For example, go back to 2007–2008. The price of oil per barrel went from $50 to $150 and then all the way down to $35 at the depths of the financial crisis. Flash ahead a few years to 2011: Oil had recovered to $115 only to drop by 35% from May to October. And even recently from 2017 to 2018, oil prices nearly doubled only to give it all back in three months.

And even in the 2021–2022 climb, we’ve seen oil rise from $50 at the beginning of 2021 to $130 earlier this year. But along the way, there were drops of 17%, 19% and 25%, and today oil sits 21% below the high earlier from this year. And don’t think I’m cherry-picking with oil. Look at lumber prices over the last two years—that’s even a wilder ride. So be cautious and aware that commodities are very volatile, much more volatile than stocks or bonds.

The second point when investing in commodities is getting direct access. It’s very difficult because if you buy a contract on the New York Mercantile Exchange or the Chicago Exchange, you’re buying a contract that you must take delivery of the oil when that contract matures. And I don’t think many of us can store barrels of oil or bushels of wheat once we take delivery of them—you have to use other investment vehicles.

There are funds and ETFs that invest in commodities, but it doesn’t give you the same investment experience. I won’t get into the details of the plumbing of these investment vehicles, but just know that the way that they’re designed, you don’t get the exact return that you do by investing directly in the commodity.

Sometimes you get better returns and sometimes worse, but it’s just not the same. So just be aware of some of these issues when investing with commodities. One of the things that you can do is invest in commodity-linked stocks. So instead of investing in oil, you can invest in the stocks of companies that drill and extract oil from the ground, including energy companies. These companies have done very well year to date up nearly 45%.

There are other ways to take advantage or to protect against rising inflation. If you get into the fixed-income realm, there are a couple of areas you can invest in as well. The first are called Treasury Inflation-Protected Securities (TIPS). These are Treasurys issued by the U.S. government where the principal and the interest payments are adjusted by inflation, so you do get some protection there.

But TIPS are sensitive to movements and interest rates, and because rates have been rising, those bonds have fallen this year; though not as much as traditional bonds. TIPS are down about 5%.

Finally, one other way you can protect against inflation is to invest in floating-rate bonds. They’re not necessarily linked to inflation, but they are protected against rising rates and I think a lot of investors associate rising rates with inflation. The interest rate that these bonds pay is linked to a short-term benchmark like the fed funds rate—when the Federal Reserve raises the fed funds rate, the interest payment on these floating rate bonds adjusts higher. So that’s a protection against rising rates, which is typically what’s seen during inflation.

And again, this is a double-edged sword because if the fed funds rate drops, the interest rate payment on these bonds will drop as well.

Click here for a replay of Stocks, Bonds and the Fog of War—Our Investment Perspective. Please contact us at (800) 492-6868 to learn more about comprehensive wealth management solutions.

*Webinar recorded after the market closed on Wednesday, April 20, 2022.

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