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Tuesday, November 16, 2010

An " Investing Strategy "For Those That Think Inflation Is Going Sky High

I noticed some commentators outside the economic/financial world recommending that folk pay down their own debt to prepare for the coming high inflation.

In fact the correct strategy would be to borrow as much at a fixed rate as possible and invest the proceeds even if it goes for now into a 6 month or one year cd at  around 1%. or invest it in inflation protected bonds with a druation that matches the maturity of the loan.

In an inflation scenario the borrower would be paying pack the loan with dollars that are worth less against a principal that does dont increase with inflation. Additionally the interest rate would be fixed at its nominal interest rate, as rates rise with inflation and with high inflation the nominal interest rate will become a negative real (nominal -inflation rate).

On the investment side as inflation rises so would nominal interest rates. As the CDs roll over the new investment rate would be higher compensating for the increase in inflation.

With the inflation protected bonds the bonds inflation adjusted component would of course increase with inflation, Even with the fixed interest rate on some maturities of TIPs negative the strategy still holds as the inflation adjustment would still be worthwhile.

Think this strategy doesn't make sense ? It's exactly what major corporations are doing in the bond market. The onlly different is that they are either sitting on the cash they raise, paying dividends, buying back stocks or are looking around for acquisitions like the large Caterpillar deal announced yesterday.

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