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Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

3 Simple Ways Everyone Can Hedge Against Inflation

In case you haven't heard, inflation is on its way. Unprecedented levels of government debt and deficits will likely weaken the value of the dollar at some point, thus raising the prices of everything it buys.

The Federal Reserve says there's no significant inflation yet. In fact, it recently said there might be too little inflation and will likely keep interest rates low for the foreseeable future. But meanwhile, commodity prices are going through the roof.

The price of copper has more than tripled since the end of 2008, oil is near $90 a barrel (also near the high since the financial crisis) and prices of several food commodities like corn and wheat are near all-time highs. These materials are in turn used to make many consumer goods. It's only a matter of time before higher input prices come out the other end in the form of higher prices for consumer goods.

In fact, inflation has started to appear already.

Although the U.S. inflation rate is still relatively low, ominous signs have begun to appear. For example, the 10-year Treasury rate has risen to about 3.48%, a significant hike from 2.48% just five months ago. Longer term rates reflect, in part, expectations of inflation in the future and go up as the outlook for inflation increases.

Other signs of inflation are appearing overseas. Inflation in the U.K. rose to 3.7% in December 2010, the highest level in eight months and well above a target of 2%. Emerging market economies like China are seeing even more inflation. The country has been raising interest rates to fight inflation, which soared to 4.6% in 2010 and rose to 5.3% in January. Brazil has forecast an inflation rate of nearly 6% for 2011 as well, up from 5.9% in 2010, which was the highest since 2004.

These are storm clouds that portend inflation. Now is the time to protect your portfolio before it actually arrives.

Here are three investments that can help protect your portfolio against rising inflation.

1. Commodities
A great way to hedge against inflation is by investing in hard assets that tend to maintain value in times of rising prices. Commodities such as minerals, grains, metals, sugar, cotton, livestock and oil typically rise in price along with inflation. In fact, when the consumer price index (CPI) increased from 3% in May of 1972 to 11% in December of 1974, the S&P Goldman Sachs Commodity Index rose 222%, a 55% average annual gain.

There are a number of exchange-traded funds (ETFs) that invest in specific commodities, as well as those that invest in many different commodities. I suggested in a recent article three commodity-oriented stock investments that should not only thrive in times of inflation, but also have solid growth prospects even without it.

[Learn more in our InvestingAnswers feature: Beginners Guide to Commodities -- How to Play 2011.]

2. Treasury Inflation-Protected Securities (TIPS)
TIPS are bonds issued by the U.S. Treasury that are indexed to inflation, as measured by the Consumer Price Index. Here's how it works...

Assume a $1,000 par value bond was purchased with a 3% yield. A $1,000 bond would initially pay $30 a year ($1,000 X 3%). If inflation was 5% the first year, the face value of the TIPS would adjust upward by 5%, to $1,050, and the 3% yield would increase to $31.50 because it would be based on the higher face value ($1,050 X 3% = $31.50).

Although these bonds typically pay less interest initially than traditional bonds, the principal value of the bonds will keep pace with inflation, and income from the securities will rise as well. These bonds are well-suited for investors seeking to maintain principal and purchasing power in the face of inflation. But they will not provide a high level of current income.

One of the easiest ways to gain exposure to TIPS is with the iShares Barclays Capital U.S. Treasury Inflation Protected Securities (NYSE: TIP). In addition to providing daily liquidity, this ETF has a low expense ratio of 0.20% per year, pays monthly distributions and currently yields about 2.5%.

3. Adjustable Rate Funds
As the name suggests, these funds invest in bonds that have rates or yields that adjust periodically. These funds are a great way to keep pace with rising interest rates, and the share price tends to remain relatively stable.

There are two major types of adjustable rate bond funds: bank loan funds and adjustable-rate mortgages. Bank loan funds invest in senior-secured debt of lower credit-rated companies, while adjustable-rate mortgage funds invest in mortgage bonds, typically guaranteed by the federal government or its agencies.

Bank loans held by funds are often loans to companies with less than investment-grade ratings. However, the loans are very short-term, giving lenders the opportunity to frequently raise the interest rate. This ability to keep pace with interest rate changes also helps keep your principal more stable than the typical bond fund.

Fidelity Floating Rate High Income (Nasdaq: FFRHX) is an excellent no-load bank loan fund that currently yields about 3.5%. The fund was one of the best performers in the category during a tumultuous 2008.

If you wait until inflation arrives, it might be too late to invest in these securities at reasonable prices. It may make sense to invest now with at least a portion of your portfolio and be prepared.

[InvestingAnswers feature: Gold Prices in 2011 -- Is the Party Over?.]