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How to Hedge Inflation and Avoid the Biggest Bond Risk

Bonds are less volatile than stocks – but in the long-term they’re just as risky. This post examines the best ways to hedge inflation risk.

By Adam Collins On 4 min read
Zimbabwe currency note for 100 trillion dollars

There’s a big difference between volatility and risk. Volatility is the magnitude of short-term price changes. Risk is the potential of permanently losing money.

“Uncertainty is not the same as risk. Indeed, when great uncertainty drives securities prices to especially low levels, they often become less risky investments.”Seth Klarman

Bonds are less volatile than stocks – but in the long-term they’re just as risky. Long-term US Treasury bond investors lost 60% in inflation-adjusted terms from 1940 to 1981.

Chart showing the inflation-adjusted drawdowns of stocks and bonds from 1900 to 2010. Both stocks and bonds have lost more than 60% after inflation.
Source: Credit Suisse

Inflation is the biggest long-term risk for bond investors. A 10-year Treasury bond yielding 7% in 1976 might have seemed like a fair rate at the time – but annual inflation accelerated to 15% by 1981, completely eroding the yield’s true value.

Treasury inflation-protected securities (TIPS) are not exposed to this risk since their principal and interest are adjusted higher with inflation. US TIPS were first issued in 1997 and are still thought of as the new kid on the bond block. The nature of TIPS cash flows make them more similar to bonds of 100 years ago than the regular Treasuries we think of as the “original” bonds.

Inflation behaved differently before countries abandoned the gold standard. Inflation was volatile, but not persistent.

Chart showing annual U.S. inflation rate from 1775 to 2015.
Source: Wall Street Journal

A lack of long-term inflation meant a bond investor in the 1800s was confident $1 in the present would buy the same amount of goods in the future. Pre-inflation government bond yields were essentially the same as after-inflation yields.

Chart showing nominal British government bond yields and after-inflation British government bond yields. The lines are similar until the UK left the gold standard.
Source: VOX

The disappearance of the gold standard resulted in a “thousand year flood” for bond investors.

Quote from The Four Pillars of Investing by Dr. William Bernstein on how leaving the gold standard changed the nature of bond returns.
Source: The Four Pillars of Investing

Inflation Hedges

The chart below shows the correlation of major asset classes to inflation.

Chart showing the correlation between inflation and major asset classes like stocks, bonds, and real estate.
Source: Vanguard

Investors should care more about correlation to unexpected inflation – expected inflation is already baked into current market prices.

All TIPS receive the same inflation adjustment, so you might wonder why short-term TIPS exhibit a higher correlation. Short-term TIPS have a lower duration than long-term TIPS and are less sensitive to changes in real yields. This means inflation-indexed income payments make up a larger portion of the investment’s total return. Additionally, long-term TIPS have more to do with inflation experienced over the entire life of the bond – not an immediate inflation shock.

TIPS don’t offer a perfect 1.0 correlation to inflation since TIPS prices move inversely to real yields in the short-term. It’s important to not get caught up in correlation minutiae – TIPS held to maturity guarantee a real return regardless of the path they take along the way.

Gold is not an effective inflation hedge for time horizons that matter. The inflation-adjusted price of gold has fallen for extended stretches of time. If gold closely tracked inflation its inflation-adjusted price would be a horizontal line.

Chart showing the real price of gold since 1975. The line is volatility - meaning gold doesn't exactly track inflation
Source: The Golden Constant

It’s true that gold investors do have (extremely) long-term data on their side. The annual pay of a U.S. Army private, in ounces of gold, is roughly equal to how much a Roman soldier earned in gold. That said, it doesn’t help an investor if their gold allocation trailed inflation during their lifetime only to gain it back thirty years later.

Stocks and REITs are not effective short-term inflation hedges. Both stocks and REITS have outperformed inflation over extended periods of time – but this doesn’t mean they’re inflation hedges. Companies can eventually pass on higher costs and REITs can eventually raise rents. Your inflation adjustment will come, but it might be years after inflation takes off.

Chart showing the lack of correlation between REITs and inflation
Source: Greenline Partners

Cash is not an inflation hedge. There have been multiple 10+ year periods where Treasury bills have failed to outpace inflation. The ability of cash to hedge inflation is a function of how benevolent central bankers are in giving savers a fair rate.

Based on the post-crisis experience, I wouldn’t be comfortable betting on cash to provide investors with a real return in the future.

Source and Disclosures


  • Regular bonds are risky in the long-term since they’re vulnerable to inflation.
  • The inflation-protected cash flows of TIPS make them similar to bonds before the era of persistent inflation.
  • TIPS have historically exhibited a high positive correlation to unexpected inflation.

This is the second in a 5-part series on TIPS. Here are links to the other posts:

  • Part 1: The Origin of TIPS, How They Work, and an All Weather Mistake
  • Part 3: The Largest Arbitrage Ever Documented – TIPS in 2008
  • Part 4: Debunking TIPS Tax Inefficiency + A Tax Deferred Alternative
  • Part 5: When TIPS Outperform and How I Invest in Them