A HIGH-DIVIDEND INFLATION HEDGE? ISHARES BARCLAYS TIPS BOND ETF (TIP)

1. MARKET OVERVIEW

Since the vast majority of stock prices move in synch with the major indices, we must evaluate any new investing in the context of the overall market’s direction.

A. MARKET STATUS

Confirmed, though decelerating (?) downtrend, still seeking a bottom.

IMPLICATIONS FOR INCOME STOCK INVESTORS

Invest in income stocks only funds with not needed for the next number of years. Invest only in companies with prospering businesses that can sustain their high dividends. These are the stocks I covered in this blog. As long as we continue to get great returns in at least the 7% - 10% range with capital reserved for investment, we can relax about the vicissitudes of stock prices.

B. DISCUSSION

Despite the optimism accompanying the new US administration, the current picture obviously remains bleak.

· The financial system remains in critical condition, though may stabilize if central bank life support systems continue to function

· The housing crisis appears likely to worsen as a wave of defaults approach in 2009

· Layoffs are occurring by the thousands

· Consumers are continuing to reduce spending

· Various key infrastructures (utility, transportation, energy, health care, to name a few) need major investment after years of neglect

The House of Representative’s version of the stimulus bill appears unlikely to work. In sum:

· It does little to improve investment in the productive assets and new technologies that will generate future jobs and wealth in the US. The bill needs much heavier emphasis on tax credits for business investment. If you buy a capital asset (computer, truck, software package, etc) you get $5000 off your tax bill, or you can just pay that $5000 in taxes. Most business owners would rather get something for their money instead of paying it away in taxes. That gets orders up and people hired and doing productive work.

· Improvements in roads and other infrastructure, while necessary, provide temporary jobs and stimulus, but very little direct impact on long term growth. A new road doesn’t cause another new road to be built, though easing traffic in theory (?) speeds transportation and perhaps lowers shipping costs, etc.

· Tax breaks and credits to low and middle income workers essentially just transfers wealth from those who create it to those who don’t, and who may or may not create additional stimulus through their spending. Tax credits for those who may now owe any tax anyway are just glorified welfare.

Let’s hope the Senate can make some meaningful improvements, or things are getting bleaker still.

2. A HIGH-DIVIDEND STOCK AND INFLATION HEDGE? ISHARES BARCLAYS TIPS BOND ETF (TIP)

Treasury Inflation-Protected Securities (TIPS) are marketable securities whose principle rises or falls with the Consumer Price Index.

For a those interested in some background on these, see

http://www.treasurydirect.gov/indiv/research/indepth/tips/res_tips.htm.

Recently there have been a number of recommendations for investments like this. The basic, simplified theory behind them is:

· the US prints more money to pay for the various bailout and stimulus packages

· these programs work at least well enough to prevent financial collapse and resulting deflation

· the overabundance of dollars causes inflation

Thus those seeking a conservative inflation hedge with some income should consider this variation TIPs.

As a service to my readers, a brief summary of the pros AND cons is in order.

A. WHAT

A member of the iShares Trust fund family, this Exchange Traded Fund (ETF) seeks to match the performance of the inflation-protected sector of the US Treasury market as defined by the Barclays Capital U.S. TIPS Index. For more on its basics, see its profile at http://finance.yahoo.com/q/pr?s=TIP

B. WHY

· Interest rates are unlikely to go much lower, with10 year Treasuries at about 2.5%.

· Interest rates should increase over the coming year as the US sells bonds (i.e. prints money) to pay for the trillions in bailouts, causing inflation, a drop in the dollar, and ultimately a rise in interest rates.

· As rates rise, foreign buyers drive up demand for Treasuries, especially those with some inflation protection for added yield.

· When credit markets are very nervous and deflation fears overcome inflation worries, as 10/08 and 11/08, TIP yielded over 9%. As sentiment has reversed, prices for TIP have climbed and the yield as a bit over 6% (based on the assumption that its $0.80 monthly dividend continues).

In sum, solid dividend and good potential for capital appreciation.

C. WHY NOT

· The fund has in fact not paid a dividend since October and it’s unclear when it will resume and at what level. Thus yield is in fact uncertain.

· The US Government’s CPI consistently underestimates inflation, so the TIPs are at best a partial protection.

· While credit has loosened somewhat recently, there is still lots of fear and Treasuries have been bid up as investors flee to quality. Treasuries are questionable bargains at these levels.

· Certain commodity-based investments, especially energy, arguably offer better appreciation (and hence inflation protection) potential given the current level of energy and other key commodity prices.

D. CONCLUSION

At best, TIP is an income producing inflation hedge of uncertain yield for those seeking to diversify a portion of their portfolio into bonds. However, there are investments available with better risk/reward ratios, like the best of the energy infrastructure MLP, power utilities, and certain Canadian Royalty Trusts. They hold or are linked to underpriced hard assets, and their yields are higher and more reliable, and they have better prospects for long term appreciation.

In sum, don’t overload on TIP and variations on this theme. Despite the hype, there are better opportunities unless you specifically seek TIPs exposure for some conservative diversification.

DISCLOSURE: THE AUTHOR HAS NO INTEREST IN TIP