Hedging against inflation

My former boss, Dr. Cayetano W. Paderanga Jr., has forwarded me this timely piece of write up that is not only relevant but is also informative. This piece was taken from IDEA’s latest Economic Trends.

According to IDEA, “inflation hedges can be defined as investment instruments designed to protect against inflation risks. During periods of high inflation, ordinary investment instruments yield lower returns as high inflation inevitably leads to an erosion of their earnings’ value. On the other hand, the underlying value of such inflation hedges typically increase during times of high inflation. Commonly cited inflation hedges are shareholder stocks of companies engaged in the natural resources industry, such as the mining of precious metals like gold or silver. Following developments in the financial sector, newer investment assets have become popular as inflation hedges. For example, money market funds that pay higher yields as inflation rises are now believed to be good inflation hedges. In times of hyperinflation, however, hard assets like precious metals and real estate are considered to be the safest inflation hedges available. Paper-based assets like stocks and bonds have been found to be poor hedges during times of hyperinflation.”

Furthermore, it was reported that “since inflation inevitably leads to lower purchasing power, investors look for ways in securing their portfolio value while yielding decent returns in the short run. This is where investments in precious metals—gold, in particular—come in. For risk adverse investors, especially those whose life cycle prevents them from absorbing more risks, safer investment assets are now available in the market. For one, index-linked financial instruments offer annuities that are tied to a basket of consumer goods or the consumer price index (CPI). This type of inflation hedge is commonly used for pensioners whose retirement annuities promise a certain level of returns. Because of this, index-linked financial instruments are justifiably the near-perfect inflation hedge. Though these bonds are effective cover against inflation, their long-run returns are expected to be lower relative to nominal bonds since holders of the latter would demand higher interest in exchange for bearing more risks.”

Lastly, it was said that “though rates have been fairly stable since 2003, there was a drop in the yield curve rates in early 2008. This happened as investors quickly shifted their funds to safer US government securities as the extent of the damage suffered by Wall Street stemming from the mortgage crisis unfolds. Investors are willing to receive yields below 0.5% in exchange for the guarantee of safe investment return. A note of caution, though. Since these bonds are tied to the domestic currency, it would make sense for foreign investors to invest in these instruments if the respective foreign currencies maintain purchasing power parity. Since adjustments for these bonds depend on a six-month lag, investors are still not spared from losses no matter how small it may appear to be,” according to IDEA.

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