Even if the politicians in Washington do manage to raise the debt ceiling, all the red ink and all the money printed by the Federal Reserve to prop up the economy over the past three years make it likely, according to some experts, that inflation could be on the rise and that reality has many investors understandably unnerved.

As Christine Benz, Morningstar's director of personal finance told On Wall Street, “Inflation is very hard to predict. In fact it’s probably not a great use of time to try and figure out when and how much inflation there is going to be. But historically, it happens, so investors should do something give their portfolios a fighting chance.”

She said the Morningstar lifetime allocation program recommends that 10%-30% of the fixed-income weighting in a portfolio have inflation protection.

There are ways to do this and the Morningstar has some advice on some of those ways that have proven track records and are relatively inexpensive options.

First, Benz recommends inflation-protected bonds. These come in two varieties: I-Bonds, which are issued by the Treasury and which have their yields adjusted semi-annually (the current rate for new I-Bonds is 4.60%) in accordance with the BLS’s Consumer Price Index, and TIPS bonds, where the principal is adjusted for inflation. 

There are no funds of I-Bonds, so investors would just have to buy them (they are sold in units as small as $50 denomination). For TIPs, Morningstar says “it’s tough to beat” the Vanguard Inflation-Protected Securities Fund (VIPSX) or, for those who like exchange-traded funds (ETFs), the SPDR DB International government Inflation-Protected Bond (WIP), which also allows some diversification from the dollar (another way to beat dollar inflation).

Benz warns that at the moment, because of so much talk about inflation, TIPS are a “little pricey.”  

A second approach to protecting a portfolio against inflation, she said, is bank loan, because their payouts fluctuate in line with the London Interbank Offered Rate (LIBOR) -- the rate banks charge each other to borrow money. To access these loans for a portfolio, Morningstar recommends the Fidelity Floating Rate High Income Fund (FFRHX), which analysts report “assiduously avoids” riskier loans.

Aside from debt, Benz says there are two other ways to hedge portfolios against inflation.

One tried-and-true inflation strategy is commodities and metals funds where Morningstar is recommending an indirect approach: owning the shares of commodities companies, rather than directly investing in the commodities themselves.

Among the vehicles Morningstar recommends for doing this are the T. Rowe Price New Era Fund (PRNEX), the PIMCO-managed Harbor Commodity Real Return Fund (HACMX) and, for ETF fans, the iPath DJ-UBS Commodity Index ETF (DJP).

Finally, Benz said certain companies' stocks can do well in an inflationary environment.

She said Morningstar’s analysts have used a screen for firms with high return on equity to identify several funds that are likely to feature such companies. All feature companies that have a record of paying dividends.

Among the picks: Vanguard Dividend Growth (VDIGX), T. Rowe Price Dividend Growth (PRDGX) and Vanguard Dividend Appreciation, which is available both as a mutual fund (VDAIX) and as an ETF (VIG).



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