How to Invest With Deflation

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People usually worry about inflation -- the rising price of goods and services -- because it erodes the purchasing power of their money. So how come they're now worrying about the exact opposite, deflation -- the falling price of goods and services? The Consumer Price Index fell 0.7% in December, after an even more precipitous fall of 1.7% in November.

Deflation is a much rarer economic phenomenon than inflation; the last time it happened in the United States was in the 1930s. If inflation is bad, shouldn't deflation be good? Well, we all know how the 1930s worked out.

It's much more complicated
Some economists fear deflation more than inflation. Deflation means that the falling prices of assets cause losses in the banking system -- because the outstanding debts supported by those assets don't fall in tandem with asset prices.

The obvious example now is housing: As the price of a house falls, the value of the mortgage remains the same, causing negative equity for the homeowner, who ends up owing the bank more than the house is worth. This causes big losses in the banking system, since the collateral that supports the loans is inadequate. The victims du jour make regular headlines on the issue: banks like Citigroup (NYSE: C  ) and Bank of America (NYSE: BAC  ) , among others.

One possible workaround
While deflation is terrible for banks, it's great for long-dated, high-quality bonds. The highest-quality bonds by default are U.S. Treasuries, and the longest-dated Treasury bonds come in 30-year maturities. While it is a little burdensome for individual investors to buy single bonds, which have a face value of $10,000, they can easily do so via the Barclays 20+ Year Treasury Bond Fund (NYSE: TLT  ) . The fund rose from a low of $88.59 last June to a high of $123.15 in December. With this ETF, you also get dividends that approximate the yield on 30-year Treasury bonds -- which was recently around 3%.

You can also look at high-quality corporate bonds, which are easily accessible via the iBoxx $Investment Grade Corporate Bond Fund (NYSE: LQD  ) . Corporate bonds were very volatile last fall, but the highest-quality issues were the first ones to snap back. And with a current yield around 5.5%, this corporate bond ETF pays a lot better than comparable Treasuries.

Bottom line, and to put it simply: Deflation is bad for banks ... but great for high-quality bonds.

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 Fool contributor Ivan Martchev does not own shares in any of the companies in this story. Bank of America is a former Motley Fool Income Investor recommendation. The Fool has a disclosure policy.

Read/Post Comments (2) | Recommend This Article (7)

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  • Report this Comment On January 22, 2009, at 12:35 PM, prginww wrote:

    MF rarely mentions bonds. Today, bonds are a great investment as we may be in a bear market for the next two years, despite occasional bear market rallies. Intermediate corporate bonds still have relatively wide spreads and yield around 5.5-6%. Great for diversification and income. Note: Long AGG and Fidelity Investment Grade Bond Fund.

  • Report this Comment On January 22, 2009, at 1:57 PM, prginww wrote:

    I'm surprised to see broad market advice from MF. They are usually pumping their recommendations.

    Yes, long, quality bonds are good in periods of deflation, but watchout for signs of inflation as their prices can collapse very quickly.

    Long: LQD and TIP.

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