Don't let inflation bite — how to hedge with TIPS, commodities and infrastructure funds

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Inflation will be in the crosshairs Wednesday as investors digest the latest Consumer Price Index. The reading may be one more sign that inflation remains a problem that isn't going away.

It's a tricky situation for investors looking for protection, but there are some good ways to get it.

Treasury Inflation-Protected securities (TIPS) are one option with "real" yields now at multi-decade highs. Beyond TIPS, analysts suggest commodities, infrastructure, and other assets that can hedge against rising prices.

While inflation is down sharply from its 9.1% peak in 2022 — a supply shock due to the Covid pandemic — it's still well above the Federal Reserve's 2% target. The headline Consumer Price Index is expected to hit 3.6% in September, partly due to rising energy costs stemming from the war with Iran. The Personal Consumption Expenditures index, the Fed's preferred gauge, was at a 3% core rate in August.

Americans' inflation concerns are also rising. The New York Fed's Survey of Consumer Expectations showed the one-year inflation outlook in September climbed to 3.9%, its highest level since May 2023.

Despite their name, TIPS haven't provided much inflation protection this year. The iShares TIPS Bond ETF, which tracks the ICE U.S. Treasury Inflation Linked Bond Index, has a total return of -1.16% year-to-date.

Like most other bonds, TIPS have been hit hard by rising interest rates — with the 10-year Treasury note recently hitting multi-year highs around 5.3%. Bond prices and yields move inversely, and as rates climbed many TIPS funds suffered.

But rising yields have made TIPS more attractive. The 10-year TIPS yield is currently at 2.87%, after closing at 2.951% on Oct. 5, levels not seen since November 2008, according to Tradeweb.

"Given where rates are, it's getting interesting," says Jason Draho, head of asset allocation Americas at UBS Global Wealth Management.

10-year TIPS yield year to date

TIPS pay a fixed coupon, or interest rate, but as inflation moves higher, the principal value of the bond increases. The adjustments reflect changes in inflation, based on the non-seasonally adjusted CPI for All Urban Consumers, with a three-month lag.

The upshot is that TIPS investors earn interest on a higher principal value over time. That's the essence of the protection compared to traditional Treasuries.

TIPS' poor performance this year isn't because of a surge in inflation expectations. Almost all the increase has been due to rising real yields — the nominal yield minus expected inflation. Real yields are up because of factors like robust economic growth and a U.S. fiscal deficit around 6% of gross domestic product (requiring far more government borrowing).

If nominal rates were rising just due to inflation, then TIPS total return — a mix of yield and price — would be fine, said R.J. Gallo, chief investment officer of global fixed income at Federated Hermes. But that isn't the case.

"TIPS have produced losses in total return because their income accruals have been insufficient to offset the price decline produced by the rising underlying real yields," Gallo explained.

iShares TIPS Bond ETF year to date

TIPS maturing in 10 years or more are highly sensitive to duration risk, Draho notes. "You're making a big call on rates not rising any further if you buy TIPS, especially longer maturities of 10-year plus," he said.

The bull case is that inflation comes down quicker than expected. That's not the market's expectation, based on short-term Treasury yields, notes Draho. But if inflation does ease next year, which he expects, the yield curve would adjust lower.

One way to manage duration risk is to own individual TIPS rather than a fund that has to maintain duration consistent with a benchmark index. Investors could create a TIPS bond ladder with varying maturities, pegged to their income needs over the next decade, for instance.

If you hold a TIPS to maturity you may experience price volatility, but you'll get the original principal or inflation-adjusted price, whichever is greater, when the bond matures.

Short-term TIPS provide more protection against rate increases and they look attractive, said PIMCO portfolio manager Greg Sharenow.

"While as a firm, our view is that inflation will ultimately come down, that view keeps on being pushed out as real world events unfold," he said. "We've seen over and over again the last five to seven years — where we're now in our third supply shock — that you end up actually underpricing versus realized inflation," he added.

Funds focusing on short-term TIPS include Vanguard Short-Term Inflation-Protected Securities ETF, iShares 0-5 Year TIPS Bond ETF and PIMCO 1-5 Year US TIPS Index ETF.

TIPS, of course, aren't the only way to go. Rick Rieder, BlackRock's chief investment officer for global fixed income, suggests a multi-pronged strategy, including equities, commodities, and alternative assets.

"I'd start layering in more income, keep interest-rate exposure moderate, and then what a lot of people are doing is use things like alternatives to to create more balance in a portfolio," he said. "That makes a lot of sense to me."

Broad inflation-protection funds include State Street Multi-Asset Real Return ETF, Fidelity Strategic Real Return Fund and PIMCO Inflation Response Multi-Asset Fund.

The PIMCO fund's holdings include TIPS, commodities, gold and real estate investment trusts.

"The idea is to have a number of different exposures so that we can have a more balanced return and not try to be so specific in getting the exact right asset class at any one moment," said Sharenow, a manager on the fund.

He adds that he sees "significant value" in TIPS, which have the heaviest weighting in the portfolio. Commodities are the next largest holding. They have price "pass-throughs," which is how much companies can shift costs to customers through price increases. That is beneficial to investors, he noted.

Separately, the fund holds about 10% each in gold and REITs.

Draho recommends commodities, based partly on long-term asset-allocation studies that include the 1970s when inflation was far higher. "Over a long period they can help reduce risk and improve diversification," he said. "Their benefits have been most pronounced when inflation was overshooting expectations."

Rather than picking individual commodities, he suggests owning a basket that's consistently rebalanced. Gold and oil, for instance, perform well in different economic and monetary policy scenarios, and it can be tricky to get the timing right.

Commodity ETFs to consider include the Invesco Optimum Yield Diversified Commodity Strategy ETF (PDBC) and the iShares S&P GSCI Commodity-Indexed Trust (GSG).

Another asset class Draho suggests is infrastructure — operators of roads, ports, bridges, and other hard assets. Companies in the space tend to be toll takers, collecting long-term revenue under contracts that include inflation riders or built-in price adjustments.

Investors can get exposure to infrastructure through ETFs such as the iShares Global Infrastructure ETF (IGF) and ProShares DJ Brookfield Global Infrastructure ETF (TOLZ).

Draho isn't sounding alarms on inflation but says it makes sense to add protection against another move higher.

"The risk now is there will be supply side shocks that could push up inflation again," he said. 

— CNBC's Daren Fonda contributed reporting.