Grow Your Income Faster Than Inflation
Good afternoon EWT, one of the issues we have been discussing at HDO are the real risks of rising inflation and its devastating effects for those who cannot offset inflation with higher paychecks, such as retirees, or those near retirement. These risks can also be devastating, even if you are employed and saving towards building your nest egg. We published an article to members last week highlighting some areas that we are focussing on to hedge against inflation risk. Below is a portion of that article.
The good news is that there are some investment strategies which - if carefully followed - can provide a degree of protection from this risk and help you grow your income faster than inflation. With that in mind, let's take a look at some options that investors have to protect themselves from inflation.
The United States has not really had an inflationary period in which energy prices were not strong. As a general rule, energy (gasoline, heating oil, etc.) is not including in calculations of "core" inflation but the reality is that rising energy prices affect transportation costs throughout the economy, feedstock costs for many industries, and space conditioning costs for a multitude of businesses, so that rising energy prices work their way quickly into core inflation through these indirect channels.
Thus, energy stocks - including Midstream energy companies such as Enterprise Products Partners (EPD) which yields 7.8% - would be expected to do relatively well during a period of inflation and may serve as a partial hedge against inflation risk.
Real Estate & Property REITs
The general increase in real estate values during inflationary periods also suggests that property REITs may be a reasonable hedge against inflation. Property REITs own real estate (or in other words 'real' assets) so they are inherently inflation resistant as real estate prices tend to go up as inflation trends higher.
These are examples of some of the best sub-sectors of REITs to hold when inflation hits us:
- The industrial sector: This sub-sector frequently has 3-7 year leases, allowing for rent to be increased relatively quickly. Unfortunately, this sector has low yields, but you can gain exposure through CEFs like RQI or RFI.
- Residential apartments: They typically have annual leases, meaning that inflation is reflected extremely quickly. BRT Apartments (BRT) is one of our favorites.
- “Triple-Net” REITs such as Realty Income (O) or W.P. Carey (WPC) have 10+ year leases, but the majority of those leases have built-in escalators that increase rent based on inflation indexes. An extra benefit for the triple-net space is that the tenant is responsible for property-level expenses, so these REITs get the extra revenue, but they have limited exposure to expenses that go up due to inflation.
Floating Rate Investments
The markets offer many floating-rate investments such as:
- Floating rate bank loan Closed-End Funds (or CEFs).
- Floating rate corporate bond CEFs.
- Short-term maturity loans (ranging from 1 month to 12 months), and thus acting similar to floating rate products. These can also be purchased via CEFs.
- Business Development Companies (or BDCs). Many BDCs (but not all) have most of their investments based on floating rates.
- CLOs: "Collateralized Loan Obligations" or CLOs have their coupon “float” over the prevailing interest rate. This makes their prices less sensitive to changes in the prevailing interest rate and inflation. Examples include OXLC or XFLT.
- Commercial mortgage REITs: These investments own "floating rate loans" secured by real estate. So they benefit from real estate values increasing and from rising interest rates. Right now is still too early, but once LIBOR goes over the average "floor" rate for their assets then rising rates becomes a major benefit.
While inflation over the next two years is unlikely to be significant, there are several factors at play that will create a "ripe" environment for a much higher inflation level in the years 2023 and beyond. These forces include excess liquidity, overprinting dollars, excess government spending, excess borrowing, irrational high asset valuations, and late (or pre-emptive move) by the Fed to control inflation.
Inflation can be devastating if you are not well prepared, and must always be factored into the consideration of investors - especially retiree investors who cannot offset inflation with higher paychecks. The good news is that there are some strategies which - if carefully followed - can provide a degree of protection from this risk and help you grow your income faster than inflation. In the coming months, we are going to be moving our portfolios into more assets that are insulated from or benefit from inflation.
Disclosure: I am/we are long OXLC, XFLT, O, WPC, RQI, EPD
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