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Inflation Bonds are One of the Best Assets You Can Own Today  Thumbnail

Inflation Bonds are One of the Best Assets You Can Own Today

We last wrote about inflation bonds or I-bonds in November of 2021 when they were yielding 7.12%. Now the rate is even better: 9.62%. For a refresher of the basics, please revisit our earlier write-up. One important point to remember is that the coupon on the bonds resets every 6 months. The purpose of this post is to discuss why rates are likely to remain elevated for a while.

There are many iterations of consumer price inflation (CPI). The Federal Reserve typically likes to use the version that excludes food and energy form their favored "core" CPI. Excluding these vital items of life seems crazy to most people. Their justification is that food and energy prices are volatile and tend to correct if they get too extreme. By using a smoothed measure of inflation, they can avoid changing monetary policy too often and act with greater predictability. 

For inflation bond investors, the good news is that we don’t have to worry about whether or not that omission is justified. The inflation rate that is used to determine the coupon on inflation bonds is:

Consumer Price Index for all Urban Consumers for all items, including food and energy

A dollar invested in an inflation bond truly protects your purchasing power. The most recent headline inflation number shocked economists and markets with a reading of 9.1%. A dollar in the bank earning near zero just became worth 9.1% less. But a dollar in your inflation bonds will be worth $1.09 in a year. Additionally, not everyone’s consumption basket is the same. If you own a home with a fixed mortgage and perhaps a slightly used Toyota Camry a good portion of your consumption basket did not rise in cost at all. You are paying more at the gas pump and at the grocery store, but your overall inflation rate on all of your expenditures is most likely less than 9.1%. So on balance, you are winning with your money invested in inflation bonds.  

The good news for inflation bond holders is that the largest portion of CPI-U is in homeowner's equivalent rent or "shelter." 33% of the inflation measure is virtually guaranteed to remain high for years, boosting your inflation bond yield.

Rob Arnott, founder of Research Affiliates, recently made some very interesting comments about why:

“A third of inflation is shelter. Back in the ’70s and early ’80s, they defined shelter inflation by rate of change of rents for renters and home prices for homeowners. [Then] they were horrified at inflation breaking out above 14%.   

So they reasoned—and it was self-serving reasoning, because they really didn't like the high numbers that they had to print—a homeowner doesn't feel the rise in the price of the house as inflation, their costs aren't going up unless they’re new buyers. Why don't we calculate what the home would rent for and treat the rising cost of an imputed estimated rent as the inflation that a homeowner would actually feel?  

That's an artificial construct. It's, by definition and by design, smoothed and slowed and behind the curve. When home prices soar, you have home prices that are up almost 40% in the last 28 months. That's an enormous rise. And owners’ equivalent rent in the last 2 1/2 years is up just about 8%. That's all just under 4% annualized.  

So what happens to that difference, that 30 percentage point difference? It shows up over the next decade, with about half of it showing up in the next three years. That means we're going to see inflation run hot for the next three years by about 5% a year. So that means owners’ equivalent rent is going to be running in the 6-10% range per year for the next three years.

You've got a third of the Consumer Price Index baked in to run hot unless the Fed is so tight that home prices crash. And so they can wind up wrecking the economy, wrecking home prices. But I don't think they're going to go that far. I don't think they're going to create a housing crash. I think they will create a recession most likely.

If housing prices stabilize right where they are, you're still going to get 6-10% inflation for the next two, three years. This is a long way of saying I think inflation will run to high single digits through end of next year and perhaps into 2024. The consensus is a lot more benign than that. I hope the consensus is right. I don't think [it is].”  

So, parsing out the optimism from that otherwise dour, but insightful, commentary, inflation bonds remain a winning place to park as much of your capital as you can. As a reminder, you are only allowed to buy $10,000 per family member per year. If you are already maxed out for 2022, we recommend setting a calendar reminder to buy more on January 2, 2023. And probably 2024!

The material in this article, provided by Mulholland & Kuperstock Asset Management, is designed to provide informative and current information as of the date of the post. It should not be considered, nor is it intended to constitute, financial or tax advice or promise similar outcomes. For information on your personal circumstances, please contact Mulholland & Kuperstock Asset Management at 310-988-2158.