The opportunities in TIPS may be fading, however. The secular trend of declining interest rates has pushed TIPS yields into negative territory, and the securities' lengthy durations could pose notable risks should interest rates rise from their current, historically low levels.

In contrast, the Lord Abbett Inflation Focused Strategy can provide a targeted approach to inflation protection with a total return that seeks to exceed the rate of inflation over a full economic cycle with reduced interest-rate risk. Using a combination of short-duration credit securities and swaps based on the Consumer Price Index (CPI),¹ the Strategy seeks a positive level of real income and capital appreciation during periods of accelerating inflation.

Is Inflation Protection Needed?
It could be said that there are a couple of constants in the U.S. economy. The first is that its composition is always changing as certain industries become more prominent while others fade. The second is the consistent trend of rising inflation.

Since 1945, for example, the CPI has increased at an average annual rate of about 4.0%, with only three years of declines, of which each was less than 1.2%. The annual level of the CPI reflects the long-term trend for inflation (see Chart 1), and the notable increase that occurred in the early 1970s coincides with the United States' departure from the gold standard.

While the consistency of the CPI trend suggests further price increases, the trend could also accelerate from its recent trajectory, considering that the root of inflation "is always and everywhere a monetary phenomenon," as the economist Milton Friedman explained. After all, since the onset of the financial crisis of 2008–09, there has been an unprecedented loosening of global monetary policies.

This monetary accommodation has not only been reflected by an environment of historically low interest rates but it also has been apparent in the significant expansion of central bank balance sheets as they pumped liquidity into the financial system. In the case of the U.S. Federal Reserve, its balance sheet has nearly tripled in size since 2008, to nearly $2.9 trillion (see Chart 2).

Considering the deluge of liquidity supplied by the central banks, an increase in the demand for money could eventually lead to faster inflation. And after a steep decline during the recession, bank lending for real estate and commercial and industrial loans has recently rebounded (see Chart 3). Further increases in bank lending could indicate that the velocity of the money supply is accelerating, thus raising the risk of faster inflation. At some point, an increase in inflation would conceivably be addressed by policymakers and the markets with higher interest rates.

Other factors that could influence inflation over the long run include how further development in emerging market economies might affect the demand for goods and services and how future technological advances might affect productivity levels.

Although TIPS breakevens² recently reflected moderate long-term inflation expectations of around 2%, the combination of several factors reflects that the threat of accelerating inflation is present. This presence may make it a suitable time to consider inflation protection for a portfolio of fixed-income investments, because once the rate of inflation accelerates, the cost of buying protection will likely increase accordingly, thus possibly limiting its potential effectiveness.

The Headwinds Facing Tips
The events of the past several years may have increased investors’ exposure to the risks of faster inflation in a couple of ways.

First, since the financial crisis of 2008–09, investors have significantly increased their fixed-income holdings at the expense of their equity exposure. Their goal may have been to achieve greater portfolio stability, but this transition has increased their exposure to assets that are particularly sensitive to rising interest rates and inflation. Meanwhile, investors' reduced holdings of assets that experienced the greatest volatility during the financial crisis, such as stocks, real estate, and commodities, are also those that historically have provided a hedge against rising interest rates and inflation.

Second, there may be mounting headwinds affecting the ability of TIPS to adequately protect against faster inflation and higher interest rates. TIPS reflect real yields—or nominal Treasury yields minus inflation expectations—and TIPS with maturities as long as 10 years recently have been issued with negative yields, as inflation expectations have exceeded nominal interest rates. Investors buying TIPS with negative yields are essentially forgoing income for the potential of principal appreciation at maturity.

Principal appreciation on a TIPS issue could occur, for example, if the CPI were to rise by 2% in a given year, thus increasing the principal of a TIPS issue from 100 to 102. The mechanics of a TIPS principal adjustment is an important aspect for income-sensitive investors to comprehend because it does not necessarily translate into meaningfully higher income as well.

Indeed, with 10-year TIPS recently issued with a coupon of 0.125%, this theoretical increase in the principal would only increase the annual interest payment by slightly more than one cent. (See Chart 4 for details on a recent 10-year TIPS issue and the long-term trend of 10-year TIPS yields.)

The minimal income provided by TIPS can also affect their market performance. During periods of rising interest rates, the minimal income from TIPS provides investors with very little to reinvest in newly issued securities with higher coupons. This aspect contributes to the duration risk from TIPS and underscores their positive correlation with nominal Treasury securities.

For example, the yield on the 10-year nominal Treasury note jumped from 2.52% to 3.70% during the period of October 14, 2010, through February 10, 2011, leading to a loss of 4.45% on a benchmark index of Treasury securities.³ During the same period, a benchmark TIPS index posted a loss of 5.27%.⁴

The sensitivity of TIPS to movements in interest rates is reflected by an average duration⁵ of about 6.7 years within Morningstar's inflation-protected bond category⁶ as of late May 2012, meaning that for a 1% increase in interest rates, the category could post an average market decline of 6.7%.

Taxable investors also need to consider the tax implications when the principal of a TIPS issue adjusts for inflation. When this adjustment occurs due to an increase in the CPI, it generates a tax liability because the increase in the principal is considered ordinary income, which currently has a top tax rate of 35%. By contrast, the tax rate on long-term capital gains is 15%.

Merits of a Targeted Approach
In contrast to the potential consequences that TIPS can bring to a portfolio, the Inflation Focused Strategy seeks to provide a targeted approach to protecting purchasing power in terms of income generation, capital appreciation, and risk exposure.

With a portfolio constructed of short-term credit instruments, such as commercial mortgage-backed securities (CMBS) and investment-grade and high-yield corporate bonds, the Strategy seeks to provide not only a positive level of real income, but also one that can keep pace with changes in the rate of inflation.

Indeed, as of early June 2012, the Inflation Focused Strategy's portfolio had a dividend yield⁷ that was similar to other short-duration corporate credit portfolios. These yields historically have been above the average yield on Morningstar's inflation-protected category (see Lord Abbett's website for more portfolio characteristics of the Inflation Focused Strategy).

In terms of the other portion of a total return, the Inflation Focused Strategy also has the potential for capital appreciation when inflation expectations rise. Considering that faster inflation may accompany stronger economic growth, one source of capital appreciation could come from the securities within the portfolio as their credit spreads tighten.

Another source of capital appreciation during periods of rising inflation expectations could come from CPI swaps that mirror, or "overlay," the securities portfolio. These instruments reflect the movement in the headline CPI (including food and energy prices) and can appreciate in value if inflation expectations have increased since the swap was created and it is sold at a profit or there is a payment at maturity (see below for more on CPI swaps).

The connection of CPI swaps to actual changes in CPI means that the swaps have little correlation to nominal Treasuries and TIPS (see Chart 5). Indeed, during the aforementioned period of October 14, 2010, through February 10, 2011, when long-term interest rates rose, leading to losses on both nominal Treasury notes and TIPS, 10-year zero-coupon CPI swaps posted a positive return of 4.3%.⁸

While the Inflation Focused Strategy seeks to generate a total return that exceeds the rate of inflation, it does so with a relatively short duration, which was 1.6 years as of June 29, 2012. In addition, the portfolio is managed on a duration-neutral basis, meaning that its duration is generally close, within one-tenth of a year, for example, to that of its benchmark index. The duration-neutral approach allows the Strategy's investment professionals to emphasize credit research and security selection while removing the challenging prospect of needing to forecast movements in interest rates.

Commodities and Real Estate Introduce a Host of Additional Factors
Investors may also look to commodities or real estate to hedge against rising prices, yet these asset classes require additional analysis beyond their historical correlations to inflation.

Commodities are often regarded as an inflation hedge, but investors face the prospect of having to choose which specific commodities might provide their desired level of inflation protection. Would gold, silver, copper, oil, natural gas, lumber, wheat, or cotton provide the specific inflation protection that investors are seeking? The choice can be difficult, especially considering that each of those commodities trades on its own market and is subject to different fundamental factors affecting supply and demand.

For example, moderating economic growth in China could influence the prices on a variety of commodities, regardless of the direction and pace of inflation within the United States. A similar dynamic could occur with real estate, as it would be subject to the whims of the housing and commercial property markets, which would not necessarily be tied to the rate of inflation.

The various factors that can influence the supply and demand for commodities and real estate-related securities have also led to price swings that, historically, have been far more volatile than changes in the rate of inflation. Indeed, the standard deviations⁹ on indexes tracking real estate investment trusts and commodities were several times higher than those tracking inflation and five-year CPI swaps from January 2004 through June 30, 2012 (see Chart 6).

Conclusion
While the Inflation Focused Strategy's role in a portfolio is to provide a total return that potentially outpaces the rate of inflation, investors should also consider how the Strategy's combination of short-term credit securities and CPI swaps might perform if inflation slows down.

An environment where the rate of inflation cools would probably coincide with weaker economic activity and, therefore, lower interest rates and losses on CPI swaps. This scenario could adversely affect the performance of the Inflation Focused Strategy. But what would happen to the other fixed-income holdings within a portfolio? These holdings would likely gain in value during a theoretical period of decelerating inflation.

The sensitivity of the Inflation Focused Strategy to changes in inflation is why it can provide a targeted approach to protecting against rising prices. Slower inflation would conceivably benefit the broader fixed-income holdings within a portfolio, but if inflation accelerates, the Strategy may provide targeted protection for a portfolio against market losses and lost purchasing power.