- Real Estate Investment Trusts
- High Yields and Big Differences
- TIPS: Treasury Inflation-Protected Securities
- It’s All About The Return On Investment in the End
An era has ended. The Federal Reserve can no longer count on low inflation. Neither can anyone else, especially investors.
The Fed can’t adjust the Fed Funds Rate to near-zero percent as it has since the Great Recession over a decade ago unless the trend changes, which it has not.
This has been heralded as a risk for a long time but was easy for the Fed to ignore. Then the important information, the stuff that the Fed watches closely, took a dramatic turn in 2021.
I know, this makes eyes glaze over. I assure you it does, even for data wonks like everyone around here. But it matters, and I’m pretty sure I can sum it up quickly in a way virtually no one else has.
Let’s take a moment to look at some real data with a chart from the Fed itself to see what it is dealing with now:
So, what’re we seeing here? The Fed can lower the Fed Fund Rate (blue line) as long as inflation (red line) didn’t exceed what the Fed decided the economy could tolerate, especially if inflation didn’t dramatically increase.
The long-term trend was downward after the “stagflation” years. The many years after the Great Recession was manageable. Now the Fed is way behind the curve. The initial reaction to the recent surge was to treat it as a blip, a temporary deviation. It was a costly mistake.
The Fed is in a purely reactionary mode. Businesses and investors are being dragged along.
Inflation hedges will have a meaningful effect for the first time in over a decade. Not all investments are equal, and nothing exposes their differences more than the cost of debt.
With that in mind, here are some of the best inflation hedges to watch. Real hedges – investments that will work now while inflation is high and won’t turn against you if that changes.
Real Estate Investment Trusts
Let’s start with something that is all the rage in the news – real estate – and how investors have been making steady returns from it in good times and bad.
There is money to be made by owning real estate besides your own house. Maybe it’s another house. Maybe that property houses your business. Odds are you want to lease it out for any other reason.
Regardless, it is capital-intensive. And if you cannot fully utilize what you own, it's a liability if it is idle. Plus, how much money is involved makes one bad tenant a nightmare.
Why not pool money with others? Why not outsource finding properties to others?
That’s why REITs were created. They occupy what once was a very quiet niche of the investment market that has seen trillions – big T there – flood in over the last several decades, and for a good reason.
They evolved from private investment deals – still very common – but offer the advantage of fractional ownership. You can invest far less than any one property is worth.
They come with very specific conditions, though. We’ll skip over a couple, but for what we need to know, they must:
- Invest at least 75% of total assets in real estate, cash, or U.S. Treasuries
- Gain at least 75% of their income from rent, interest on mortgages, or real estate sales
- Return a minimum of 90% taxable income as dividends to shareholders per year
In short, REITs have a narrow mandate and pass everything on to their investors. Income and profits, but also taxes.
When properly managed, REITs cycle their debt. They pull in money from investors but still use debt to fund what they own. Kind of like mortgages but on far more advantageous terms. The trick is to balance this against cash flow from the people and businesses they lease properties to on your behalf.
Good REITs constantly balance that over time and don’t run into any problems. Bad ones make big refinancing bets to keep the “return to shareholder” requirement work in the short term and pray they can cover it later.
These are some of the highest-yielding investments available over time, but it all depends on management.
It’s all about balancing cash flow and percentages over time. The REIT company staff has to be stringently SEC compliant, but you must also do your due diligence.
A good REIT has a good CEO making deals. The best REITs have CEOs that listen to their accountants while they wheel-and-deal and keep their investors in the loop.
Speaking of cash flow and yields, that leads us to something else we should discuss. High-yield dividend companies…
High Yields and Big Differences
I’ll be frank. There are two kinds of high-yield companies out there. Those that are thriving and those that are dying.
The ones you want to pay attention to consistently have the free cash flow to return money to their shareholders.
The ones you don’t want to bother with are the ones that have dividend yields that seem high because their share prices have recently dropped. This makes the yield seem high based on the last dividend payment. A lot of the information on dividend yields looks to the past.
This is what matters – dividend-paying companies need to have cash in the bank when it comes time to pay their investors. They’ll need to replenish it consistently. They’ll need to increase it over time.
We want to see a healthy balance of capital investment that allows the company to grow while also providing free cash flow that persists regardless of stock price changes.
With interest rates going up, this isn't easy, but it is also their core business model. It’s the one thing high-yield dividend companies need to deliver.
Several sectors are packed with great dividend-paying companies. Consumer goods, utilities, midstream energy, and financial services stand out.
They’re companies that need to focus on efficiency despite regulation or other limitations. They can grow but can’t grab market share with any one big, bold push. Instead, they make incremental, deliberate capital investments with long time frames.
Dividend aristocrat stocks stand out here. They’re companies that have consistently increased their dividend payments, without fail, for at least 25 years.
TIPS: Treasury Inflation-Protected Securities
Wrapping back to where we began – the Fed and interest rates – a pure inflation hedge is easy to find with TIPS – Treasury Inflation-Protected Securities.
Bonds are normally very stable investments. At least for how they are structured. None more so than those issues by stable governments.
TIPS are designed to add an extra layer. They adjust based on inflation. But the devil is in the details.
The U.S. Treasury issues TIPS regularly with 5, 10, or 30-year maturities in increments of $100 with interest paid every six months.
The rate does not change after the bond is sold. They do not adjust for inflation in this way. Instead, as quoted from the U.S. Treasury, the “amount you get is based on the principal at the time of each interest payment, and the principal can go up or down.”
Yeah, that isn’t much help. What exactly does this mean? What’s the difference between TIPS and regular bonds, and where is there any advantage to them?
First up, the government designed these so the principal, and thus the “face value” of these bonds, remains relatively stable.
If inflation goes up between when the bond is sold by the U.S. Treasury through when it matures, you get more or less based on the change in inflation when the Treasury issues interest payments every six months.
That stabilizes what these bonds are worth between buyers and sellers of them in secondary markets in the 5, 10, or 30 years between when they are issued and when they mature.
Second, there is room for some downside protection. It’s pretty clear how bonds that adjust for inflation over time can be useful if inflation goes up, but also – as the U.S. Treasury describes them – you always “get either the increased (inflation-adjusted) price or the original principal, whichever is greater. You never get less than the original principal.”
These investments are excellent for investors that are comfortable locking their money into long-term bonds.
There may be some short-term market conditions where they can be sold to other investors at outsized profits, but they are designed to be extremely stable.
Having said that, be very careful to ensure you’re buying TIPS at a fair price. Just because they are designed to be stable doesn’t mean someone won’t try to sell them to you at an unfair markup.
Many retirement fund providers have options incorporating TIPS but keep in mind they’ll take their cut, and an actively managed fund like that will rotate bonds in a way that can dilute their value.
It’s All About The Return On Investment
Inflation hedging isn’t something that grabs a lot of attention. You won’t buy rounds at the bar and tell your buddies about your investing prowess.
Jim Cramer isn’t going to be on the verge of tears, pounding on his table, about how you’re missing out.
But you will quietly do far better if you keep this in mind – inflation hedging is all consistent returns on investment.
Keeping two ideas firmly entrenched in your mind will work wonders:
- Inflation hedges should consistently return money to investors
- Inflation hedges should not come with conditions
Debt should be managed, cash flow should be steady, and neither should change much if at all.
Good hedges don’t need validation. They keep chugging along, putting money back into our accounts.
These days, they’re a good thing to have, and we’ll keep covering them going forward.
The Profit Sector