Yesterday, the Federal Reserved hiked what it charges banks for emergency loans. The move won’t affect corporate or consumer loans, but it’s a reminder that as the economic recovery advances, we’ll be seeing more rate increases.

The Federal Funds rate has been sitting around a low of between 0% and 0.25%, which has helped encourage borrowing and lower the cost of capital for individuals and businesses, comments Amanda B. Kish for The Motley Fool. As the Fed moves off these lows, you might find yourself needing to make adjustments to your portfolio. [Fed Hikes Rates.]

Bonds will be the first to take a hit. As rates rise, bonds become less lucrative since investors can buy newer ones with higher yields. One way to offset some interest-rate risk is by keeping bond allocations in short-term bond investments. Another option is to keep some money in inflation-protected securities (TIPs), which are indexed to inflation. More risk-tolerant investors may consider high-yield bonds – the likelihood of corporate defaults also drops as the economy improves. [Protect Against Big Deficits.]

• iShares Barclays 1-3 Year Treasury Bond (NYSEArca: SHY)
• iShares iBoxx $ High Yield Corporate Bond Fund (NYSEArca: HYG)
• SPDR Lehman High Yield Bond (NYSEArca: JNK)
• PIMCO Broad U.S. TIPS (NYSEArca: TIPZ)
• PIMCO 15+ Year U.S. TIPS (NYSEArca: LTPZ)
• PIMCO 1-5 Year U.S. TIPS (NYSEArca: STPZ)
• iShares Barclays TIPS Bond (NYSEArca: TIP)
• SPDR Barclays Capital TIPS (NYSEArca: IPE)

The Fed may find itself in the position of needing to raise rates while unemployment remains relatively high, which likely means that the stock market won’t react to the decision favorably. Higher rates affect how companies borrow money and how they conduct business. Dividend-producing stocks may be a good choice in the long-term. Interest rate hikes usually coincide with an improving economy and companies tend to dish out higher dividends as an economy improves. [How to Play a Dividend Comeback.]

• Wisdom Tree Dividend ex-Financial (NYSEArca: DTN)
• iShares Dow Jones Select Dividend Index (NYSEArca: DVY)
• PowerShares High Yield Dividend Achievers (NYSEArca: PEY)
• Vanguard Dividend Appreciation (NYSEArca: VIG)

For full disclosure, some of Tom Lydon’s clients own shares of SHY and TIP.

Max Chen contributed to this article.

The Obama administration is estimating that the federal budget could double over the next decade and Moody’s Investor Service is warning that the U.S.’s AAA credit rating “could come under downward pressure” as a result, according to The Wall Street Journal. The increasing amount of government debt could set off a “triple whammy” of weak economic growth, higher inflation and higher tax bills, says Laurence Siegel, director of Research Foundation of the CFA Institute

President Barack Obama is considering raising taxes on the wealthy, increasing top rates to 39.6% from 35%, and pushing capital gains and dividends top rates to 20% from 15%. There are main strategies to help lower one’s tax burdens: First, start a Roth IRA or convert a traditional IRA into a Roth. Second, take advantage of low capital-gains rates and sell highly appreciated assets. Lastly, the tax-free income of municipal bonds become more attractive as taxes increase.

• PIMCO Intermediate Municipal Bond Strategy Fund (NYSEArca: MUNI)
• PowerShares Insured National Muni Bond (NYSEArca: PZA)
• iShares S&P National Municipal Bond Fund (NYSEArca: MUB)
• SPDR Lehman Municipal Bond ETF (NYSEArca: TFI)

When the U.S. dollar depreciates, the value of assets priced in foreign currencies tend to rise. Charlie Gushee, head of Western European sales at Auerbach Grayson & Co., suggests putting money into stable, dividend-paying foreign firms “that have zero or next to no dollar revenues.” Investing in emerging markets is also prudent since companies in these markets have dollar-denominated debt, which would be easier to pay if their local currency appreciated.

• WisdomTree International Large Cap Dividend (NYSEArca: DOL)
• WisdomTree International Utilities (NYSEArca: DBU)
• Vanguard Emerging Markets (NYSEArca: VWO)
• Emerging Global Shares Dow Jones Emerging Markets Energy Titans (NYSEArca: EEO)
  

If inflation rises, investors should consider switching regular bonds like Treasuries to Treasury Inflation-Protected Securities (TIPS). TIPS bond’s principal and interest payments grow with inflation. However, worried investors have been bidding up prices of TIPS, which is dampening yields. You may also think about corporate bonds, municipals and savings bonds, but the investments may have higher fees and difficult to sell if inflation abates.

• PIMCO Broad U.S. TIPS (NYSEArca: TIPZ)
• PIMCO 15+ Year U.S. TIPS (NYSEArca: LTPZ)
• PIMCO 1-5 Year U.S. TIPS (NYSEArca: STPZ)
• iShares Barclays TIPS Bond (NYSEArca: TIP)
• SPDR Barclays Capital TIPS (NYSEArca: IPE)

Commodities usually go up when basic materials become pricier during inflationary times. Commodity ETFs would give investors an opportunity to invest in the basic building blocks of everyday life. Still, it should be noted that a stagnant economy could weigh down commodity prices.

• iShares S&P GSCI Commodity-Indexed Trust (NYSEArca: GSG)
• PowerShares DB Agricultural Fund (NYSEArca: DBA)
• Market Vectors RVE Hard Assets Producers (NYSEArca: HAP)

For more information on investing in ETFs, visit our ETF 101 category.

Max Chen contributed to this article.

A bond is a loan that a bond purchaser makes to a company, as stated in American Chronicle. Thomas E. Murphy, certified financial planner at TEMAA Financial, says bonds serve to reduce volatility in a portfolio while generating income – the quarterly, semi-annual or annual fixed income is generally more than dividend payments from stocks. [iShares launches muni bond funds.]

Bonds have an inverse relationship with market interest rates – the price of a bond falls as interest rates rise. Bond investors may use a strategy called “laddering” to decrease interest rate risk by buying bonds of various maturities. As a bond matures, you may reinvest in higher-yielding bonds if rates rise. [What to watch as yields rise.]

One option for diversifying your bond holdings is by buying ETFs, which give exposure to hundreds or even thousands of bonds in one single transaction. However, it’s important to approach your bond portfolio as you would your equity portfolio and to be prepared to adjust as conditions change. [Why it's time to approach bonds differently.]

The decline in inflation, which is practically at zero, and the sharp decline in market interest rates may be indicators of a reversal of fortune for the Treasury bond market, writes Paul J. Lim for CNN Money. Peng Chen, president of the investment consulting firm Ibbotson Associates, believes a bear market in Treasuries may occur if inflation rises and the Fed has to raise interest rates.

Here are three strategies for the fixed-income investor:

• Don’t want to incur loses? There is virtually no credit risk if you stick to U.S. Treasuries since the government won’t default on the loan. But rates may rise and reduce your bonds’ value in the open market.  Among your options: Reduce risk by keeping to short-term exposure, which reduces vulnerability to price swings; keep a portion of Treasuries in individual issues and ladder your securities; and/or put some money away into Treasury inflation-protected securities (TIPs). [What to watch as bond yield rises.]
• More risk-tolerant? Consider taking on sovereign debt of other countries. Foreign debt also has the added benefit of a exchange rates, especially if the U.S. dollar is weakening. An easy way to access international Treasuries is through ETFs. [Diversify with international bonds.]
• Not too risky, but not too safe? Try adding some municipal or corporate bonds into the mix. It should be noted that munis are also free from federal tax and, in some cases, state and local taxes. Corporate bonds also help reduce a portfolio’s potential exposure to losses.

For more information on bonds, visit our bond category.

• iShares Barclays Aggregate Bond Fund (NYSEArca: AGG)
• Vanguard Total Bond Market (NYSEArca: BND)
• iShares Barclays 7-10 Year Treasury Fund (NYSEArca: IEI)
• SPDR Barclays Capital High Yield Junk (NYSEArca:JNK)
• iShares iBoxx $ High Yield Corporate Bond (NYSEArca: HYG)
• SPDR Barclays Capital Short-Term Corporate Bond (NYSEArca: SCPB)
• SPDR Barclay International Treasury Bond Fund (NYSEArca: BWX)
• SPDR Barclays Short Term International Treasury Fund (NYSEArca: BWZ)
• iShares Barclays TIPs Bond ETF (NYSEArca: TIP)
• SPDR Barclays Capital TIPS (NYSEArca: IPE)
• PIMCO 1-5 Year U.S. TIPS (NYSEArca: STPZ)
• iShares S&P National Municipal Bond (NYSEArca: MUB)
• SPDR Barclays Capital Short-Term Muni Bond (NYSEArca: SHM)

Max Chen contributed to this article.

As Allen Robinson for Global Investors points out, a rise in yield often precedes a Treasury announcement as investors anticipate that the increase in bond supply will cause prices to fall and yields to rise. These increasing rates also signal that investors are growing increasingly concerned about inflation. [Why it's time to look at bond ETFs differently.]

David Bogoslaw for BusinessWeek gives investors a few clues about what they should be watching amid the conflicting views about inflation:

• Asset bubbles and consumer prices: Many strategists believe the economy has too much slack for any meaningful rise in consumer prices in 2010. It’s possible for asset bubbles to form even when consumer prices are stable or in decline. [Are there clues in the yield curve?]
• 5-Year TIPS: Investors who are still worried about inflation reaching 3% to 5% down the road to wait for a cheaper entry point into TIPS, which could occur if CPI figures start to come down in the months ahead. With inflation pressures so benign, don’t expect the Fed to start raising rates until the fourth quarter of 2010, says one strategist.
• Withdrawing the stimulus: If inflation is rising at a slower pace this year, but investors are becoming more concerned about inflation over the medium term, TIPS can still do very well relative to nominal Treasuries. By pricing 10-year TIPS at 2.40%, just below the baseline inflation rate of 2.5% expected over the coming 10 years, the market is saying it expects the Fed to get its timing right and withdraw the fiscal and monetary stimulus before they lead to inflation.
• No Wage Inflation: Unemployment is expected to stay high over the next few years, meaning wages could become stagnant. Investors who live on most of the total return in their fixed-income portfolios this year will come from the coupon interest on the bonds they own.
• Protectionism grows stronger: Economic conflicts over trade deficits could spark a new wave of protectionism – a bigger risk than military conflicts. But that would lead to deflation, not inflation, because the unavailability of certain resources would hamper economic expansion.
• Emerging markets look inviting: Opportunity for higher returns in corporate bonds in the more robust emerging markets will abound, where credit spreads have contracted substantially but there’s still room for further contraction.

For more stories about bonds, visit our bond category.

• iShares Barclays TIPs Bond ETF (NYSEArca: TIP)

• SPDR Barclays Capital TIPS (NYSEArca: IPE)

• PIMCO 1-5 Year U.S. TIPS (NYSEArca: STPZ)

WisdomTree

The new ETF WisdomTree has in the hopper, the WisdomTree Real Return Fund (NYSEArca: RRF), seeks to give investors long-term returns above the rate of inflation.

Liquidity has flooded the U.S. market, giving rise to investor fears that inflation will soon become an issue. This new fund aims to give investors another way to hedge it, explains Cinthia Murphy for Index Universe.

The fund’s primary goal is for its portfolio to have an average effective duration of two to 10 years, and maturity lengths will vary. The longer the duration of the securities, the more susceptible the fund is to interest rate fluctuations and volatility. (Read on about ways to hedge inflation with ETFs).

RRF will also deliver exposure to commodities, such as energy, precious metals and agriculture. RRF will compete directly with IndexIQ’s newest offering, IQ CPI Inflation Hedged (NYSEArca: CPI). (More about CPI can be found here).

Inflation fears have fueled an increase in products designed to hedge it. PIMCO recently launched the first short-term TIPS ETF, PIMCO 1-5 Year U.S. TIPS Index (NYSEArca: STPZ), and other providers also have TIPS funds. (How TIPS work).

For more stories about TIPs, visit our TIPs category.

• iShares Lehman TIPS Fund (NYSEArca: TIP)

• SPDR Barclay TIPS ETF (NYSEArca: IPE)

What are TIPS?

TIPS are Treasury Inflation-Protected Securities. TIPS are similar to regular Treasury bonds in that they have the same credit risk – effectively none – and they’re issued by the government. But the difference is how they pay the coupon. “If you buy $100 at inception and the rate of inflation is currently 2% for 10 years (the date of maturity), the principal will grow 2% each year,” Caltagirone says.

When were they created?

They were created in the United States in 1997. It was something the Treasury had thought about doing for awhile, Caltagirone says. We’re far from the first country to offer them – the United Kingdom has had them since the 1980s. But the U.S. market for TIPS is now the largest in the world.

Why were they created?

The main reason TIPS were created was to give the public a debt instrument that is directly linked  to the rate of inflation. “No other investment where it moves up and down with whatever inflation is measured at,” Caltagirone says.

The Treasury issued them for two reasons:

• There was demand for them
• They’re incentive for the Treasury to keep inflation in check. If inflation runs rampant, the Treasury knows it will have to pay more and more to TIPS holders. “It forces them to take inflation seriously,” says Caltagirone. “They’re a check and balance for the Federal Reserve and the Treasury.”

What’s the TIPS market right now?

It’s around $550 billion. Total U.S. debt is around $12 trillion, making TIPS about 5% of the total U.S. debt. The market for TIPS has grown, Caltagirone notes, and it could grow even more.

TIPS, being relatively new instruments, have not yet been tested in a period of stagflation. Will they hold up if this happens?

In theory, Caltagirone says, TIPS would hold up in a period of stagflation – that is, high inflation, low growth. “In the late ’70s, anything over five years of maturity suffered and the yields went up sharply. Inflation is the #1 enemy of regular bond that don’t have inflation protection.”

Because TIPS strip out the price risk, the theory is that they’d hold their value better.

What are the risks of TIPS?

In short, the risk is that you could buy some TIPS and inflation doesn’t pan out like you expected it might. “If inflation doesn’t pan out,” Caltagirone says, “then you’re stuck with the lower yield.”

If a period of deflation is entered, then it cuts into your yield. The worst-case scenario is deflation; the best-case is stagflation.

What strategies can I use when it comes to TIPS?

Caltagirone says that most investors should think of TIPS as a strategic position – not one necessarily of buy-and-hold, but held for a period of time, such as one, two or three years. Tactically trading TIPS could shortchange investors of their rewards: “The benefits of them get felt out over longer periods of time.”

That’s because, Caltagirone says, inflation is very noisy in the short-term since it’s measured month-to-month. Once that’s all smoothed out, you can see where the overall trajectory is headed.

Where do TIPS fit in with other inflation hedges?

One benefit of TIPS, Caltagirone notes, is that they’re directly linked to inflation by contract. Commodities can be a useful hedge against inflation, but they’re not contractually obligated to deliver on that, so there’s no guarantee. “[Commodities] tend to drive inflation in the short-term, but over the long-term they’re not all that correlated with inflation.”

What TIPS ETFs are available?

• PIMCO Broad U.S. TIPS (NYSEArca: TIPZ)
• PIMCO 15+ Year U.S. TIPS (NYSEArca: LTPZ)
• PIMCO 1-5 Year U.S. TIPS (NYSEArca: STPZ)
• iShares Barclays TIPS Bond (NYSEArca: TIP)
• SPDR Barclays Capital TIPS (NYSEArca: IPE)

Allianz’s Pacific Investment Management Co. (PIMCO) says that TIPs often lead to missed opportunities and hidden costs, reports Ian Salisbury for The Wall Street Journal. TIPs adjust their principal to match rising prices, or in other words, they are Treasury bonds that hedge against inflation.

TIPs have rallied this year on worries over inflation, which could arise as a result of the copious government stimulus efforts. PIMCO has filed with the Securities and Exchange Commission (SEC) to launch TIPs-related ETFs in an attempt to get in on the investor interest, and all four would be index funds.

PIMCO’s paper, written by John Cavalieri, Gang Hu and Mihir Worah, points out four areas of inefficiency in the TIPS market that could be corrected through proper management during specific segments of the year or changes in the shape in the yield curve:

• Passive investors can incur larger transaction fees than active investors in the TIPs market, and passive investors won’t be able to time transactions during the day to take advantage of market imbalances that could occur at the end of the day.
• TIPs ETFs rebalance periodically and active investors can capture alpha by purchasing securities at artificially depressed prices after rebalancing.
• TIPs auctions create market inefficiencies. The funds can lose out on a chance to trade in periods when supply and demand are out of whack.
• TIPs prices also shift according to the seasonal patterns in the underlying inflation index.

Vanguard agrees with this assessment and is in favor of active management in TIPs funds. Barclays, however, dismissed Pimco’s findings, stating that ETFs trade less frequently than active funds, which lowers costs. Furthermore, Barclay insists that costs incurred are easier to judge since they are rolled into bid-and-ask spreads that investors see upon trades.

According to Robert Huebscher for Advisor Perspectives, active managers won’t be able to outperform the passive TIPs ETF in net fees, and in an attempt to outperform passive funds, active managers will also be more inclined to take excessive risks. Huebscher also notes that PIMCO may be more biased toward active management since a major chunk of the company’s revenue comes from actively managed bond portfolios.

• SPDR Barclays Capital TIPS (IPE): up 6.3% year-to-date

• iShares Lehman TIPS Bond (TIP): up 5% year-to-date

For more information on Treasury inflation protected securities, visit our TIPs category.

Max Chen contributed to this article.

Some believe that inflation is a far cry with the Consumer Price Index running at negative -1.3% over the past 12 months, real estate prices continuing to drop and stable crude oil prices, states The Wall Street Journal.  However, most prominent economists think that this trend will soon come to an end and inflation, if not hyperinflation, will emerge.  The reason for this is the weakness of the U.S. dollar and the printing of money to fund our government’s spending habits.

So how one protects oneself against rising prices is actually fairly simple.  A good way to combat inflation is through Treasury Inflation-Protected Securities (TIPS).  Another way to hedge against inflation is through the utilization of commodities, more specifically gold.  The last way to protect yourself is by using futures contracts.

The following ETFs will help enable you to take out an insurance policy on rising prices – this is just a sampling, as a number of funds out there could prove to be useful as an inflation hedge:

• SPDR Barclay Capital TIPS (IPE): up 5% year-to-date.

• iShares Barclays TIPS Bond (TIP): up 3.7% year-to-date.

• SPDR Gold Shares (GLD): up 6.8% year-to-date.

• PowerShares DB Agriculture (DBA): down 1.8% year-to-date.

For more stories on gold, visit our gold category.

Kevin Grewal contributed to this article.

Federal Reserve Governor Kevin Warsh reads recent inflation trends as positive, as there has been some price stability and deflationary risks seem tamed. Meanwhile, the Fed is keeping overnight interest rates in the 0% to 0.25% range that was hit in December and said they were likely to stay that way for some time.

Chris Isidiore for CNN money reports that the inflationary factors are evident, such as a rise in oil prices, loss of value on the dollar, and the rise on Treasury yields all signal signs of higher consumer prices. Deflation is supported by rising unemployment and low factory utilization, which may be signs that prices will fall further. This cycle would be more destructive to the economy at this point.

Despite soothing words about inflation and deflation from the Fed, there are ways to be on your guard for either scenario.

Inflation. The large volumes of money smothering the banks has economists and financial advisers worried over inflation. The main sign of inflation can be seen through the Consumer Price Index (CPI).

How To Play It. Rising inflation would deteriorate asset value over the long-term for bondholders, and a way to combat this is through Treasury Inflation-Protected Securites (TIPS). Another way to hedge against inflation is through commodities, gold being a classic inflation hedge.

• SPDR Barclays Capital TIPS (IPE)
• iShares COMEX Gold Trust (IAU)
• SPDR Gold Shares (GLD)

Deflation. A deleterious cycle can be created as banks stop lending, businesses halt expansions, wages fall, people reduce spending and prices would be driven further downward. The CPI is a good indicator for deflation.

How to Play It. Investors should look to short-term investment strategies, such as short-term certificates of deposit or money-market funds. But those with a 10-year time table could look into the technology sector since companies that seek to boost productivity will do so through technology.

• PowerShares QQQ (QQQQ)
• PowerShares Dynamic Semiconductors (PSI)

The speculation is that the Federal Reserve may have to raise interest rates sooner rather than later. The 10-year U.S. Treasury yield hit a seven-month high on Monday ahead of fresh supply this week, which also supported the U.S. dollar, reports Kevin Plumberg for the Guardian.

The U.S. dollar edged up, after higher U.S. bond yields and doubts about the speed at which central banks will diversify their dollar reserves have improved its outlook. Meanwhile, investors have their eye on Chinese economic data for clues.

Consumer demand from Asia in Western markets is one area that is watched, as well as domestic demand in China regarding economic conditions despite weak exports.

Susanne Walker and Daniel Kruger for Bloomberg report that 30-year debt fell as traders prepared for the sale of an additional $30 billion in notes and bonds in the next two days. Short-term treasuries fell as speculators and traders were wrong about the interest rates inching higher by the end of this week.

• iShares Lehman TIPS Bond (TIP): up 1% year-to-date

• SPDR Barclays TIPS ETF (IPE): up 3.8% year-to-date

For full disclosure, some of Tom Lydon’s clients own shares of TIP.