“Seasoned mutual-fund investors are more likely to fear inflation than they are deflation,” writes Karen Damato and Theo Francis in today’s The Wall Street Journal.

“But amid the current economic recession, it is deflation – a general decline in the price of goods and services – that has been in the headlines. The Great Depression was the last time the U.S. experienced a serious bout of deflation. But the price of a barrel of oil has tumbled $10 in the past year, and the Labor Department reported last month that consumer prices for October actually fell about a third of a percent from the prior month’s level.”

“So, should investors be positioning their mutual-fund portfolios with an eye to deflation, even a worst-case multiyear meltdown à la Japan? Or, given that the economy may already be bottoming, should they be fretting about a possible rebound in inflation?”

“For starters, financial advisers say, most individuals shouldn’t obsess on the inflation-deflation scenarios. “Trying to predict [inflation] and position your portfolio ahead of time is incredibly difficult,” says Bryan Olson, who runs Charles Schwab & Co.’s Center for Investment Research. “Economists and financial experts aren’t too good at it, so as an investor, it’s going to be a tough game to master.” Fundamentally, diversification is the key to surviving bouts of inflation and deflation alike, Mr. Olson and others say.”

“At the same time, investors need to be cognizant of the way different types of funds and other investments tend to perform in inflationary and deflationary environments. Here’s a primer, and a suggestion of one often-overlooked investment — funds investing in inflation-indexed bonds — that seems a particularly interesting play on the deflation-inflation uncertainty right now.”

“While falling prices might sound wonderful for someone on a tight budget, they can be brutal for stock-market investing. Plummeting prices can devastate company profits, leading to layoffs and fostering gloom among consumers, who cut back on their spending.”

“At the same time, deflation can actually add to the return on fixed-income investments. Holding a 4% bond amid 2% yearly deflation means a 6% annual gain in buying power.”

“So investors who fear an extended bout of deflation might want to cut back on their stock exposure or focus on sectors with demand that doesn’t tend to slip in bad times, such as consumer staples. Utilities — which still charge according to regulated rates in much of the country — “should benefit by deflation because they’ll be able to hold up their prices” even as their costs fall, says Roger Ibbotson, a Yale management professor and chairman of Chicago research firm Ibbotson Associates Inc.”

“Investors should also seek funds offering long-term bonds from high-quality issuers to lock in better interest rates and minimize the risk of default, adds Steven Nothern, a government bond-fund manager at MFS Investment Management. Examples of such bond funds that have performed well recently include Vanguard Long-Term Bond Index Fund and Pimco Long-Term U.S. Government Fund.”

“That said, if the economy is poised to begin climbing out of recession, planning for prolonged deflation probably doesn’t make sense. And some see signs of a recovery in the recent stock-market rally, including this week’s surge.”

“Robert Reiner, who runs international and global stock portfolios for Deutsche Asset Management, gives the U.S. a 50% chance of seeing mild deflation even a year or 18 months into a recovery, compared with a 20% chance of seeing serious deflation. But he is more worried about renewed inflation once the economy recovers.”

“Near-term, the fear is” mild deflation, he says. “Farther out, it’s inflation.”

“In an inflationary spiral, companies must pay higher prices for materials and labor and, at the same time, try to raise their own prices fast enough to keep their profits from shrinking; it’s a tough proposition, and many stocks suffer. Meanwhile, bond buyers demand higher interest rates in an effort to stay ahead of inflation, and those higher rates depress the value of bonds outstanding that carry lower interest rates.”


“During the 1970s, for example, the Standard & Poor’s 500-stock index returned an average 5.86% a year and long-term government bonds returned 5.52%, both trailing the 7.37% inflation rate, according to Ibbotson Associates.”

“Tangible assets such as real estate are often considered a hedge against inflation, but real-estate funds, which actually invest in corporate securities, don’t necessarily offer the same protection, experts say.”

@page_break@”Commodities is another tangible asset category, and fund investors looking to include an inflation hedge in their portfolios might consider the unusual Oppenheimer Real Asset Fund, which buys derivative securities whose returns are linked to commodity prices. But with commodity prices tumbling of late, the fund has declined a painful 31.45% so far this year.”

“Commodities also may not constitute a reliable inflation hedge anymore, warns Brett Hammond, director of portfolio studies at financial-services provider TIAA-CREF. “In the 1970s and 1980s, commodities tracked inflation pretty well. Around 1985, it stopped working,” though he said it is unclear why.”

“That brings us to a newer type of investment specifically designed to keep pace with inflation – inflation-indexed bonds, introduced by the Treasury Department five years ago.”

“Also known as Treasury inflation-protected securities, or TIPS, they carry a fixed interest rate (the yield is currently about 3.5% a year on bonds maturing in 2011), but that percentage is applied to a principal value that is periodically adjusted for inflation. Investors’ overall returns will be a combination of that set rate and actual future inflation.”

“Pacific Investment Management Co., the biggest mutual-fund firm specializing in bond portfolios, expects inflation to average about 2% a year for the next three to five years, suggesting that TIPS maturing in 2011 would deliver a solid 5.5% annual return for that time period.”

“TIPS offer “the comfort and security of knowing that not only your principal is protected [by the government backing], but also your purchasing power is protected” by the inflation adjustment, says John Brynjolfsson, manager of the firm’s Pimco Real Return Bond Fund, which has $2.5 billion in assets.”

“The current recession and the recent whiff of deflation present, ironically, a reason to consider the TIPS funds right now. Since investors aren’t hungry for inflation protection, TIPS are priced quite attractively relative to ordinary Treasurys of similar maturities.”

“For instance, standard Treasurys maturing in 2011 yield around 5%, just 1.5 percentage points above the current indexed-Treasury yield. The indexed Treasurys will turn out to be the better investment if inflation averages more than 1.5% during the next decade.”

“The inflation protection of indexed bonds is likely to grow more expensive whenever inflation worries resurface, just as “it is more expensive to buy earthquake insurance after a disaster,” says Casey Colton, lead manager of American Century Inflation-Adjusted Bond Fund.”

“Another TIPS fund, with particularly low annual expenses, is Vanguard Inflation-Protected Securities Fund. The indexed-bond funds from Pimco, American Century and Vanguard have returned between 7.96% and 8.83% so far this year.”

“And a curious side effect of the TIPS structure can even provide a measure of protection if deflation should reign for several years, Pimco’s Mr. Brynjolfsson notes. Deflation eats away at the bond’s principal for the purposes of calculating interest, but the government promises that, at maturity, bonds will have at least their original face value — deflation can’t erode that. As a result, he says, they make a sort of minimal hedge against sustained deflation.”