Given the dominance of inflation in today's capital markets discussion, it should be no surprise to anyone watching this video that one of the most common questions I get is, “How do I inflation-protect my portfolio?” And that's what we're going to focus on today: what to think about when you're thinking about inflation protection.
So let's start with the obvious, how effective of a hedge is it? We've done research over time on real assets, for example, and there are three lenses through which we judge the effectiveness of those hedges. The first of which is reliability, how consistent is this investment as an inflation fighter over time? Secondly, magnitude. We call it the “inflation beta.” How much does this investment move when inflation appears? And then the third, and this is really important, is cost-effectiveness. So, for example, in equities, if I was trying to look for a segment of the equity market with an inflation-protection history, I could find it. I was just talking about real assets. How about the equities of real asset producers or value, which classically tends to do reasonably well in inflationary environments?
However, we believe that a lot of the heavy lifting of inflation protection comes more at a corporate level, in the ability of a company to navigate an inflationary environment, to pass through price increases, and that allows us to not become heavily concentrated by seeking out sectors and instead be diversified and also maintain a broad exposure to market returns. Again, in pursuit of inflation protection with broad market exposure.
The same thing as it relates to fixed income. Implicitly speaking, I can just add credit if I want to try to add some level of buffer against inflation. Why? Because one of the best ways to beat rising yields for any reason is to out-yield it. It provides me with both a yield buffer and, if that inflation is coming in a reasonably strong economic environment, I can also have capital gains from spread compression inside of credit, both of them matter. But there is another side, which is explicit protection inside of the fixed-income world. And many of you know all about these, folks. Outside of the United States, these inflation link securities are often referred to as “linkers,” and inside of the United States, they're in the MIPS family. MIPS, municipal inflation-protected securities, and on the taxable side, Treasury Inflation-Protected Securities or TIPS. If you take a nominal or a garden variety treasury, and you think about the coupon, it's basically broken down into two things. One is the amount of compensation you get from the government for lending them money. The real yield. The second is compensation for expected inflation over the life of the bond so that your initial investment maintains its purchasing power all the way through maturity. But it's kind of a do-it-yourself project because, in theory, you're supposed to take that part and reinvest it into your own principle so you maintain that purchasing power.
Where a TIPS security comes in is the government does that for you. You only receive the real yield and instead, the government adjusts your principal over time by what inflation actually is. So, the real benefit is it’s explicit, but there are some limiting factors inside of the TIPS world. The first of which is the primary TIPS index that many people gravitate to has a very long duration, and that's sort of sneaky because it creates a frying-pan-and-fire scenario, because maybe I'm getting out of the frying pan by escaping the inflation risk, but am I diving headfirst into the fire? Because now I'm taking a very long duration profile translated as a lot of interest-rate risk just as a federal reserve is starting to tighten, reducing its bond purchases in pursuit of raising interest rates.
So how might I defend against that? Well, I have another obvious suggestion for you, buy shorter-maturity TIPS. Now, again, classically, we think about an index and we gravitate to it, but the reality is inflation protection for a 30-year TIP or a one-year TIP is identical. So, you have the power, if you will, to modulate your interest-rate exposure. And if you want to, marry it to your current duration profile inside of your portfolio, however, regardless, there's still limiting factors inside of the TIPS world, one of which is phantom income. That inflation adjustment that you're receiving, you have to pay taxes on every year, even though you haven't yet received it.
And the second part and probably much more important is again, there's an opportunity cost here. Yields and treasuries are incredibly low. So, let's pretend that I own a core plus portfolio that yields 2%, and I decide to migrate, sell that and move into a treasury-only portfolio, that give up in yield is significant. And remember, we talked earlier about credit. Even in a world where inflation was only 2%, yields are so low that credit is critical just to produce yields over the rate of inflation at a normalized level. So wouldn't it be nice if I could have exposure to the credit that I talked about earlier, but still have some way of accessing inflation protection? And that leads me to the third point of discussion, which is CPI swaps. Now, in this video, we don't have enough time to go through the wonkiness of how swaps operate, but at a high level, I want you to think about it as a wrapper around a portfolio.
So ideally I would be able to have a portfolio that's diversified in fixed income with government and corporate bonds and I could additionally add that wrapper around it. And in theory, CPI swaps allow you to do that. Now they don't do it for free. It costs about 15 to 25 basis points of yield for that swap. But again, if I'm starting from a higher level of base yield and subtract that cost, I am still going to probably easily outpace the yield on government-only securities, and clearly, that's meaningful. And of course, CPI swaps are not bulletproof either, because what they do is adjust your principle up or down for changes in inflation expectations up or down. But it's a great tool for investors trying to navigate price movements over time and protect real purchasing power and maintain the yield.
So if I zoom out to sum it all up, it comes down to this, whenever I'm choosing an investment as an inflation hedge, I'm looking for two things, its effectiveness as an inflation hedge in the presence of inflation, but also its performance as an asset in and of its own right in the absence of it. If we can manage that blending, then we can get the best of both worlds. To participate in a market that should be reasonable as we go forward, but also defend against the risks of inflation that all of us are facing nowadays. If you have further questions, please, because we've covered a lot of information here, reach out to your AllianceBernstein representative, but in the meantime, thanks so much for joining.