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August 11, 2006 4:19 pm

Hedging CPI: Tax-efficient tips try to beat inflation

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What worries you most about the economy? As many have pointed out, the latest data provide reasons to worry about both a slowdown and a return to inflation. Neither is likely to be good for investors.

But these fears have spurred the ingenuity of financial engineers trying to devise products that will help hedge away the risks. If you want to bet on a return to serious inflation, there is now a way to do it.

Samson Capital Advisors, a specialist fixed-income investment house for wealthy individuals, recently finished raising capital for a fund, structured as a limited liability company, that is designed to operate a tax-efficient inflation protection strategy. The idea behind it is to allow a “portable” hedge against inflation, where returns rise with inflation and remain unaffected by other variables, while doing so tax-efficiently.

The fund achieves this using the swaps market and by taking advantage of the inflation-proofing of Treasury Inflation-Protected Securities (Tips), which pay a yield fixed as a mark-up on the rate of consumer price inflation, in combination with tax-efficient municipal bonds. Tips are taxable, making them unpopular with wealthy investors, and have a nasty kicker in that you pay tax both on income and any accrued interest – hence you can pay increasing tax on Tips in years when inflation is high, even without receiving cash flow.

Samson’s strategy to make Tips tax efficient is complex and is unfashionable in the US where inflation-linked bonds are less popular compared with fixed-income bonds than in Europe.

The first step in the financial engineering behind Samson’s fund is to lock in an inflation rate. This is done through a “CPI swap”. If you buy a fixed-income bond and swap its coupon payments for the payments on a Tip, you have in effect locked in a rate of return that will vary directly with inflation.

For example, if the bonds pay a fixed 5 per cent and the Tips pay inflation plus 2.5 per cent, the swap makes money when inflation is above 2.5 per cent, and loses when it drops below. This flow of income can then be made “portable” by pairing it with another instrument.

The next step in the strategy is to add long-dated municipal bonds, which are not taxed. Samson chose high credit-quality, zero-coupon munis, whose price movements are highly correlated with treasuries. The resulting beast behaves very much like Tips, but with the benefit that returns are accrued tax-free. Because of the swap structure, it is geared to inflation.

The strategy is ingenious but does it make sense to follow it? Samson locked in an inflation rate of 3 per cent. According to its own projections, this strategy will do worse than any mainstream alternative – treasury bonds, muni bonds or equities – while inflation re-mains below 4.3 per cent, on average over the lifetime of the funds and can be expected to outperform significantly only once inflation exceeds 6.7 per cent.

US inflation last reached such a high level in 1981 when it stood at 10.3 per cent. It dropped to 6.2 per cent in 1982, and has never exceeded 5.4 per cent since. If inflation stays in anything like the range in which it has remained since Paul Volcker’s Federal Reserve moved aggressively to squeeze inflation out of the system after the 1970s oil price spikes, this strategy will almost certainly lose you money compared with the alternatives. This probably explains why inflation-linked bonds are less popular than in Europe, where beating inflation is a more recent experience.

If inflation reaches a range from 10 per cent to 14.76 per cent, the Samson strategy could reach a positive return of as much as 20 per cent, while treasuries and munis both lose money. But in effect you are placing a bet that the economy will veer out of control in a way that does not seem at all likely at the moment.

Another disadvantage is the time horizon. The CPI swaps market is very illiquid by the standards of government bonds, with only about $10m traded each day (compared with $10bn to $15bn on the Tips market and much more on conventional treasuries). There are only a few points in the curve that are truly liquid. Samson therefore organised its first offering over a fixed period of 15 years. This is a long time to lock up your money, although it is always possible that a secondary market could emerge.

Samson has a reasonable answer to these problems – arguing that this should not be a large proportion of your portfolio. If the worse comes to the worst, it will be much more bearable if you have up to 5 per cent of the portfolio in a tax-efficient form protected from inflation.

The downside is minimal and this strategy is very unlikely to lose money.

The meeting of the Federal Open Market Committee this week was one of the most contentious in years. But most would be inclined to bet that the Fed remains well enough in control to stop inflation returning to the levels where this strategy truly pays off.

For those nervous enough to place a small bet that the Fed loses control, and with enough wealth to put money away for a while, this strategy looks like a good way to do it.

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