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We are standing at challenging point in history for financial planners. Government bond yields are low, as is the apparent rate of inflation. Investors are far more concerned with the safety of their principal than with the risk of losing purchasing power.

As is so often the case, the biggest risks are those that we discount.

The possibility of a surge in interest rates appears to be todays ignored risk, despite the warnings of many experts, including David Einhorn. Bill Gross. and Seth Klarman.

Regardless of the probability of various scenarios for future inflation or the mechanisms by which they may play out, investors and advisors should consider how to most cost effectively protect their portfolios against a rise in interest rates. Perhaps the most powerful way to do that is by purchasing out-of-the-money put options on bonds.

That strategy is the focus of this article, but before I explore it, lets examine the shortcomings of the more common ways investors protect against the the loss of purchasing power through inflation and the devastating consequences that can have.

The advantage of put options over other strategies

The simplest solution is to invest the bond portion of a portfolio in inflation-protected securities (TIPS). The problem with TIPS is that the embedded inflation protection tracks the Consumer Price Index (CPI), a statistical measure of inflation that may not properly track the inflation rate that individuals experience. As David Einhorn notes, for example, health care represents only 1/16th of the CPI but 1/6th of the Gross Domestic Product. More problematic, the government both determines the calculation of the CPI and has a clear incentive to make inflation rates appear as low as possible. The government has enormous financial liabilities (e.g. Social Security) that increase with CPI.

Another approach to sheltering a portfolio from inflation is to invest in real assets, such as land, commodities, precious metals, and oil and gas wells and pipelines. Real asset prices, at least theoretically, are tied to inflation. As Klarman pointed out recently, however, gold and real assets are far from a pure play on interest rates. Even with low inflation in recent years, gold is near record highs. Commodities prices tend to go up with inflation, but they are also tied to economic growth.

Real assets, commodities, precious metals, and TIPS provide protection against increasing interest rates and have an important role in asset allocation, but they are not perfect hedges against interest rate increases.

Klarman has proposed buying put options on bonds. He is using deeply out-of-the-money put options to explicitly protect against a substantial rise in interest rates. The attraction of this approach is that put options on government bonds are truly a pure play on rising interest rates. There is no way for nominal interest rates to rise without driving down the prices of government bonds.

We are going to explore Klarmans strategy using bond ETFs, with a focus on options with a long time until expiration (called long-dated options). The use of long-dated options minimizes the need to frequently repurchase options. There are long-dated options markets on a number of bond ETFs than can provide the basis for implementing this strategy.

We are going to focus on the iShares long-term government bond index (TLT) and intermediate-term government bond index (IEF). TLT has trailing 12-month yield of 3.9% and IEF has trailing 12-month yield of 3.2%. If interest rates increase, the prices on these long- and intermediate-term bonds will decline, thereby increasing their yields. The value of put options on these ETFs will increase in this scenario, thereby gaining in value in a rising interest rate environment. Put options on these bond ETFs provide a form of insurance against rising interest rates.

Klarman emphasized that this strategy makes sense when put options are relatively inexpensive. His comments mirror Mohammed El Erians description of tail insurance as asking what a really bad state [of the world] looks like and if there is cheap insurance against it.

The cost of tail insurance matters. Investors and advisors who wish to explore the use of put options as a way to protect against a surge in inflation need to start by understanding the pricing of these options.

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