A fund that hedges against inflation

How to guard your portfolio against the effects of Washington's spending spree.

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NEW YORK (Fortune) -- Fans of tax-free muni bonds know that inflation can gnaw at their returns. And as government spending stokes fears of rising inflation, investors might be looking for protection.

One possible solution: J.P. Morgan's three-year-old Tax Aware Real Return Fund - one of the only mutual funds to combine municipal bonds with a shield against inflation.

The fund works by investing in high-quality municipal debt, which is not federally taxed. (As of March 30, 93% of bonds were AAA-, AA-, or A-rated.) It uses inflation protection derivatives, such as inflation-linked swaps, to keep pace with the Consumer Price Index.

By holding swaps and bonds of similar durations, the fund is hedged about 1 to 1. In theory, a drop in bond prices should be offset by an increase in the value of the swaps. (Of course, the same swap would reduce the potential gain on the bonds.)

"The goal of the fund is to get tax-efficient inflation protection," says Deepa Majmudar co-manager of the $2 billion fund, which has returned 8.5% this year to beat the 4.9% of the Barclays Capital 1-15 Year Municipal Bond Index. "We saw the majority of tax-sensitive clients including TIPS in their portfolios, and TIPS are very tax inefficient."

Investors typically use inflation-linked assets in portfolios to take advantage of their low correlation to stocks or bonds. As Majmudar notes, hedging against inflation reduces a portfolio's long-term volatility and risk.

One way to fight inflation is to buy Treasury Inflation Protected Securities, or TIPS, which are U.S. Treasuries whose principal amount adjusts with the CPI.

But TIPS can carry federal taxes of up to 35% in the high-earners' bracket if not held in tax-deferred accounts or a Roth IRA. The Tax Aware fund, by comparison, has a 0.77% expense ratio but is tax-free.

Rick Taormina, the fund's other co-manager, points out that retail investors can buy inflation-linked municipal bonds. But the secondary market is illiquid, so investors will have a hard time moving in and out of issues if deflation becomes a concern.

"This fund offers investors liquidity to express their view on deflation," Taormina says.

Muni Market

The municipal bond market, generally considered a safe harbor, had a rough 2008. Demand plummeted after big buyers Lehman Brothers and Bear Stearns went bankrupt and investors flooded into safer treasuries. Morningstar estimates high-yield municipal bond funds lost an average of 25%.

The Tax Aware fund lost 7.5% last year as both muni bonds plummeted and inflation concerns gave way to deflation worries. Both bond prices and inflation hedges went south, negating the hedge.

This year, however, the market has reverted as buyers return. So far in 2009, munis have outpaced equities.

"We've seen a really good rally for the muni market already this year," says Miriam Sjoblom, mutual fund analyst at Morningstar. But, as she notes, many investors are still cautious about municipal bonds as towns across the nation struggle to repay debt.

"You're going to be subject to more jolts in the muni market," Sjoblom says.

Still, Majmudar and Taormina suggest investors consider inflation protection while it remains relatively cheap. The Tax Aware fund now trades below 2006-07 levels.

Majmudar and J.P. Morgan forecast inflation to stay low - around 1-2% - in the next six months and eventually pick up in the next two or three years and further out, as a result of Washington spending.

"There's certainly a lot of risk out there from the stimulus money - that if the economy is not managed to balance between growth and inflation, it could prove inflationary in the long term," Majmudar says. "That's why we've seen a lot of interest."

For investors worried about protecting their portfolio from the effects of record federal spending, the Tax Aware fund might be worth considering.

As Taormina puts it, "You don't want to buy insurance after the house burns down." To top of page

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