The Only Way to Beat Inflation

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Investors have always looked to protect themselves from the impact of higher prices. When inflation-indexed bonds first came out more than 10 years ago, they filled a huge void for those investors. Yet although their returns are still based on price changes, these investments haven't fulfilled their promise of being a viable way for long-term investors to preserve and build their wealth.

Another one bites the dust
To convince yourself that all the opportunities in the inflation-indexed, fixed-income markets have pretty much disappeared, all you have to do is look at two pieces of recent news. Yesterday, the Treasury announced a new rate for its Series I inflation-indexed savings bonds: 0.74%, accountable solely to the inflation adjustment. Those who buy I bonds now will earn exactly the rate of inflation, without any additional interest kicker.

Earning 0% may sound like the worst you could possibly get, but last week, investors proved you can get even less than nothing. In an auction of five-year TIPS bonds, bidders set the effective yield at a rate of -0.55% -- a negative number, meaning that investors were willing to take over half a percentage point less than the rate of inflation between now and 2015.

Of course, inflation-indexed bonds aren't the only investment to lose their effectiveness in the battle against higher prices. For years, one of the main reasons people cited for paying ever-higher prices for real estate was the notion that as an inflation hedge, real estate would never lose value. That promise pushed shares of homebuilders Toll Brothers (NYSE: TOL  ) , Pulte Homes (NYSE: PHM  ) , and NVR to quadruple from 2001 to 2005. Yet as millions have discovered to their dismay, that piece of market wisdom turned out to be completely false, and it's now one of the biggest worries justifying the Federal Reserve's all-out war against potential deflation.

The last one standing
The reason I'm so disappointed about inflation-indexed bonds is that they started out with such promise. A decade ago, you could get interest rates of 3% to 4% on top of the inflation adjustment, promising you a real rate of return that would give you guaranteed growth above the rate of inflation. Yet just as the traditional bond market has seen yields drop to historic lows, so too have opportunities in the inflation-indexed arena evaporated.

That leaves only a couple of good alternatives to hedge against inflation. One is commodities, especially precious metals like gold and silver. It's hard to argue against gold lately, given that it's seen its price rise five-fold from its lows in 1999. Gaining support from aggressively accommodative monetary policy from the Fed and investor interest in precious-metals funds Central Fund of Canada (NYSE: CEF  ) and SPDR Gold Trust (NYSE: GLD  ) , prices of the yellow metal have set new records repeatedly in the past year. Moreover, many other less followed commodities, such as sugar, cotton, and base metals, have seen even bigger price moves lately.

But the fact that those commodities are expensive makes them less attractive inflation-fighters, especially if you're only getting into them now. Instead, another option is to invest in stocks with strong brands and good dividend yields. For instance, in the food arena, Heinz (NYSE: HNZ  ) , Kellogg (NYSE: K  ) , and General Mills (NYSE: GIS  ) all have well-known products that command premium prices over off-brand competition. Each pays a 3% dividend and has increased its dividend at a rate of at least 8% annually over the past five years -- even in an environment where overall prices have stayed stable. If inflation returns, these are the companies in the best position to pass on higher raw materials costs to consumers.

Roll with the punches
Everyone wishes that they could find a no-risk investment that would pay them a large enough return to ensure their financial success. Inflation-indexed bonds no longer provide that cushion of safety. With interest rates too low to be viable for most investors, you should emphasize a combination of strong-brand dividend stocks, along with reasonably priced commodities and shares of the companies that produce them, as a diversified approach toward preserving and enhancing your portfolio's purchasing power.

Fool contributor Dan Caplinger misses higher interest rates. He doesn't own shares of the companies mentioned in this article. Heinz and Kellogg are Motley Fool Income Investor recommendations. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy never raises its price.

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Dan Caplinger

Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.

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