Hedging Against Inflation and Monetary Policy Risk

July 5, 2022 – Over the last few decades, we’ve become accustomed to a negative correlation between stocks and U.S. Treasury bonds. Bonds used to serve as a great diversifier against macroeconomic risk. Specifically, the last four downturns in 1991, 2001, 2007-2009, and 2020 were all so-called “demand-side” recessions where the drop in GDP went hand-in-hand with lower inflation because a drop in demand also lowered price pressures. The Federal Reserve then lowered interest rates, which lifted bonds. This helped tremendously with hedging against the sharp declines in your stock portfolio. And in the last two recessions, central banks even deployed asset purchase programs to further bolster the returns of long-duration nominal government bonds. Sweet!

Well, just when people start treating a statistical artifact as the next Law of Thermodynamics, the whole correlation collapses. Bonds got hammered in 2022, right around the time when stocks dropped! At one point, intermediate (10Y) Treasury bonds had a worse drawdown than even the S&P 500 index. So much for diversification!

So, is the worst over now for bonds? Maybe not. The future for nominal bonds looks uncertain. We are supposed to believe that with relatively modest rate hikes, to 3.4% by the end of this year and 3.8% by the end of 2023, as predicted by the median FOMC member at the June 14/15, 2022 meeting, inflation will miraculously come under control. As I wrote in my last post, that doesn’t quite pass the smell test because it violates the Taylor Principle. The Wall Street Journal quipped, “The Cost of Wishful Thinking on Inflation Is Going Up Too”. I’m not saying that it’s impossible for inflation to subside easily, but at least we should be prepared for some significant upside risk on inflation and interest rates. Watch out for the July 13 CPI release, everybody!

So, trying to avoid nominal bonds, how do we accomplish derisking and diversification? Here are ten suggestions…

Oh, before we get started, I got one favor to ask. Please check out my recent appearance on the awesome Two Sides of FI podcast:

Eric, Jason, and I discussed my safe withdrawal rate research and my economic and financial outlook. And don’t call me the grinch of the FIRE community because I had some uplifting words for Eric who plans to retire in 2024.

Back to the issue of rising interest rates. Let me first just point out one little fun fact…

The lack of diversification between stocks and bonds wasn’t quite as bad as it’s often portrayed!

While it’s certainly true that the 10-year U.S. Treasury total return index is now almost 20% below its all-time high, keep in mind that part of the bond drawdown coincided with the equity bull market in 2020 and 2021. In other words, out of the 17.6% drawdown, “only” 10.5% occurred this year. The other portion of the drawdown came between the August 2020 bond market peak and the January 2022 stock market peak, when we still had a nice negative correlation between stocks and bonds. So, diversification from bonds was not completely ineffective. True, bonds didn’t gain when stocks lost. But at least, intermediate (10-year) Treasury bonds lost less than the stock market. Thus, a diversified portfolio would have still slightly cushioned the fall of your portfolio. Not as well as in 2008. More like in the 1970s.

Stocks vs. Bonds Total Return Indexes.

In any case, if you’re still concerned about nominal bonds coming under further pressure, here are a few ideas to deal with that risk…

1: Cash is King

With cash, I don’t mean dollars stuffed into your mattress. Think money market accounts or 3-month T-bills. The advantage is that you can participate in rising interest rates without losing your shirt from that ugly duration effect. Of course, the unpleasant side effect is that nominal yields are still very low because central banks have only recently started raising rates from bargain-basement starting points. It may certainly feel good not to lose any money but with an 8+% inflation rate, your money market account still melts at an alarming rate when looking at purchasing power. But it’s a start!

Keep some powder dry and maybe even move that cash back to longer-duration bonds once we get higher Treasury yields. Then ride down the duration effect again, like in the 1980s! And maybe you can boost your money market rate a bit by rotating your money from one intro teaser rate to the next.

One caveat, though: don’t get your hopes too high that this will miraculously generate significantly better outcomes. For example, if we run my Safe Withdrawal Rate Toolkit (see Part 28 of my Series), and calculate the failsafe withdrawal rates by decade, the improvement for the 1960s cohort is pretty meager, see the table below. You get a slight boost from 3.58% to 3.66%, about a 2% boost in the fail-safe retirement budget. That’s not a big improvement for shifting 25% of the portfolio from intermediate bonds to T-Bills!

Fail-Safe Withdrawal Rates by decade. 30-year horizon, monthly withdrawals at the beginning of the month. 25% final value target. Withdrawals and final values are adjusted for CPI inflation.

And also notice that during the 1920s and 1930s you would have done far better with the diversification benefits of bonds. But of course, the exercise here is to focus on the inflationary supply-side recessions in the 70s and 80s, not the deflationary events in the 1930s.


Treasury Inflation-Protected Securities (TIPS) are government bonds that have a fixed real rate of return, i.e., a return over and above an objective and observable inflation index, namely the U.S. (headline) CPI. If inflation is higher than expected then your return shifts up one-for-one. Sweet! That’s the definition of inflation protection!

In practice, you’ll likely not buy the actual TIPS but rather an ETF, like the iShares TIP. Unfortunately, TIPS ETFs have slightly higher expense ratios than nominal bond ETFs, for example, 0.19% per year for the iShares TIPS ETF vs. 0.05% for the overall Treasury ETF (ticker GOVT). Another problem with TIPS: the yields are still painfully low. On July 1, 2022, the yields for 5, 10, 20, and 30-year TIPS were 0.24%, 0.52%, 1.12%, 0.89%, respectively. That’s certainly better than the 0% on I-Bonds, but still very low by historical standards. Talking about I Bonds, here’s the third recommendation…

3: I Bonds

I Bonds have become something of a superstar in the personal finance community. Part of that is due to the sometimes deceptive advertising like “you can earn 9.62% in six months” as I’ve read the other on another personal finance blog the other day. That’s inaccurate. You currently earn 4.81% over the six-month window, equal to a 9.62% annualized simple (non-compounding) interest. But just to be sure, even 4.81% over six months is a very solid return when everything else is dropping like a rock. With the built-in inflation protection, your I Bonds will certainly do the trick, just like TIPS. While I Bonds share a lot of features with TIPS, there are several differences.

First, there are limits on how much you can buy every year. Usually, the maximum is $10,000 per taxpayer per year (i.e., $20k per married couple), so the average retired couple with a seven-figure net worth will not be able to move any significant chunk of their portfolio very quickly. That said, there are some “hacks” for raising this limit. For example, if you own a business and/or trust, you can get another $10,000 per entity. There’s also the option of “over-withholding” your federal taxes by $5,000 every year and then using the $5,000 federal refund to purchase more I Bonds. See The Finance Buff’s ultimate guide to I Bonds for more information. So, if you are planning a slow shift into low-risk assets during the last five years of accumulation, you can use I Bonds as one of those safe assets and accumulate a six-figure sum over the years.

Second, the value of your I Bond investment cannot go down. While TIPS can lose money when the real interest rate goes up – a duration effect just like in the case of nominal bonds – your I-Bonds are protected from changes in the principal. However, if real yields ever go down again then I Bonds will not go up in value either. So, it’s a two-sided sword!

Third, if you sell before the 5-year mark, you lose 3 months worth of interest. But again, in nominal terms, the rate is still very solid, so even if you park your money for a year in I Bonds and lose a quarter of the income you’ll likely be ahead of a money market account with a measly 1.5% interest.

Finally, the current real interest rate stinks! I Bonds currently guarantee a 0% real return, significantly lower than TIPS. With 0% real return you can pull off a 2.5% safe withdrawal rate over a 40-year horizon. With total asset depletion. I Bonds, just like TIPS, serve only as a hedge in case your equity portfolio has a Sequence Risk scenario during the first 5-10 years of your retirement. Currently, they are not a long-term solution in retirement planning!

Side note: Which one of the two, TIPS vs. I Bonds would I recommend? In light of the lower real yields and all the bureaucracy in I Bonds (annual purchase limit, registration of a Treasury Direct account, etc.), I’d probably opt for the TIPS. On the other hand, the tax efficiency of I Bonds would be a plus. Apparently, you can defer the interest for as long as you hold the bond. [thanks to commenter Spencer below for pointing this out!]

4: Gold

Historically, gold has been a pretty decent inflation hedge. In fact, it has been a pretty decent hedge against any kind of macroeconomic trouble, even demand shocks with disinflation/deflation. If we were to shift the 25% intermediate bonds portion to gold, the fail-safe withdrawal rates would have improved in the 1960s and 1970s. What’s more, you would have seen a slight improvement in the deflationary periods, i.e., the 1920s and 1930s retirement cohorts. Not a bad hedge!

Fail-Safe Withdrawal Rates by decade. 30-year horizon, monthly withdrawals at the beginning of the month. 25% final value target. Withdrawals and final values are adjusted for CPI inflation.

And the usual disclaimer applies here: ownership of gold was severely restricted in the U.S. for several decades, my simulations are more of an “academic” exercise, looking at how a hypothetical investor/retiree with today’s asset allocation options (including gold ETFs, gold futures, etc.) would have fared with historical asset return patterns.

5: U.S. stocks

Yeah, you read that right. Even though the stock market doesn’t like inflation shocks in the short-term, in the long-term, stocks tend to be a decent hedge against inflation. Eventually, corporate profits will catch up with inflation, and drag prices up as well. In fact, among four major asset classes stocks/bonds/cash/gold, U.S. equity returns have put all others to shame over the last 150 years, when calculating the long-term inflation-adjusted returns.

Real Cumulate Total Returns since 1/1871.

This is probably not a workable solution for current retirees because of Sequence Risk. A 100% equity portfolio in retirement would have been far too risky in historical simulations. But if you’re still accumulating assets and your retirement date is still years away, you might just take a chance with the stock market.

In other words, my recommendation of 100% equities during most of the accumulation phase (potentially even up until retirement) is still valid, see my SWR Series, Part 43.

6: FX-hedged international stocks

How about international stocks? Well, as I outlined in a post a few years ago, if you’re afraid of a massive bear market in the U.S., then there is relatively little room to hide in international stocks because the U.S. is the largest economy and the “consumer of last resort” for a lot of the foreign export economies. Sorry, everybody, we tend to take everyone down with us if there’s trouble! But one could argue that the Federal Reserve tightening path is ahead of most of the other major central banks. The ECB is still below zero. Japan at zero. The Bank of England started raising rates but at a much slower pace. It’s certainly possible that other economies will fare better.

But not so fast, because when rates are increasing faster in the U.S., one would expect the USD to strengthen against most of the other major currencies. Then money invested in foreign equity markets will likely lose value just from the FX effect. That happened in the 1980s under Volcker and again in the late 1990s tightening cycle. In contrast, the meek policy tightening in 2015-2018 saw only a mini-rally, roughly the same size as the current USD rise. But if the 50-75bps rate hikes keep coming at every FOMC meeting, I’d suspect the dollar could move more like the 1980s or 90s than the late 2010s.

US Dollar Index: When the Fed aggressively tightened (early 1980s, late 1990s), the USD index rallied. Source: barchart.com

So, if you hold investments abroad, you might be better served with FX-hedged funds. But needless to say, there’s no free lunch: FX-hedged funds also have higher expense ratios and they roll the hedging costs into the fund returns as well. But if you like international stocks, at least take the FX headache out of the equation.

7: Floating-rate bonds

The obvious way to avoid your fixed-income portfolio getting hammered from a duration effect is to invest in floating-rate bonds.

But here’s the catch: If you like floating-rate bonds with low-to-no credit risk and without any duration risk, well, there’s no free lunch. You likely get yields not much different from a money market account. For example, the iShares ETF (Ticker FLOT) most recently distributed $0.0422 per share in June. That’s an annualized yield of about 1.0%, given the $50 share price. I get more than that with my Fidelity money market fund, ticker SPRXX, with a yield of 1.28% as of 6/30/2022.

If you are willing to sacrifice some safety for higher returns, there’s the Invesco Senior Loan Floating Rate ETF (Ticker BKLN). It offers a yield of about 4% (based on a $0.0661 current monthly dividend, $20.27 share price), but comes with some additional credit risk. In fact, year-on-year the fund is down about 2%. In other words, the price dropped and wiped out one year of income and then some. An FDIC-insured money market account would have performed better. But granted, that past loss is water under the bridge, so maybe the floating rate ETFs will eventually catch up and earn a superior return over a simple money market account.

There are many more ETFs in this space. I won’t research all of them but see here for a list of funds sorted by AUM.

Maybe we could increase the risk level even more. That brings me to the next point…

8: Floating-rate Preferred Shares

Taking a little bit more risk, we can push up that yield going from bonds to preferred shares. A quick recap, preferred shares are a hybrid between stocks and bonds. They pay a set dividend, which can be a fixed percentage or a floating rate, or more complicated combinations. I haven’t found many offerings of preferred share ETFs focusing on floating/variable rates. Global X Variable Rate Preferred ETF (ticker PFFV) is one.

I like to buy the individual shares because it saves me the ETF expense ratio and I can pick and choose the individual preferreds I like most. Here’s my watchlist of Floating-Rate preferreds, see the table below. A few things to point out:

  • Notice that most of them are still in the fixed-rate stage, but many of them will transition to LIBOR+x% within the next few years.
  • Most of the shares pay dividends that are taxed as (qualified) dividends at the lower (potentially zero) federal income tax rate. But all of the REIT preferred shares (ACR, CIM, DX, EFC, MFA, MITT, NLY, NRZ, TWO) and one of the Citibank preferreds will pay dividends taxed as interest/ordinary income.
  • Notice that the interest rate is calculated relative to the $25 notional share value. But the yield is calculated relative to the actual share price. For most of the preferreds, the yield is a bit higher than the quoted rate because the shares are trading below par.
My Floating-Rate Preferred Share Watchlist. Yield calculated with 7/1/2022 closing price. Using a 2.3% LIBOR for the shares already tied to the LIBOR. Tickers will vary from broker to broker. For example, use “C PRN” at Interactive Brokers, but “CPRN” at Fidelity. For quotes, use “C-PN” at YahooFinance, but “C-N” at Google Finance.

And by the way, I’m keenly aware of the irony here, because, in my Safe Withdrawal Rate Series, I’ve warned about the dangers of chasing higher yields, see Part 29, Part 30, and Part 31. Preferred shares have significant credit risk. In the Great Recession of 2008/9, the preferred market had a drawdown roughly as bad as the stock market. So, if you use preferreds today you will implicitly assume that the potential 2022 market slowdown will be different from the Global Financial Crisis. That’s not a crazy assumption because I don’t see a repeat of the subprime mortgage meltdown this time around. The large global financial sector players (Bank of America, Citibank, Goldman Sachs, Morgan Stanley, State Street, and Wells Fargo) will likely do OK. Smaller and regional players (Keystone, M&T, PNC, etc.) probably too. But I would at most “sprinkle in” the Mortgage REITs. Even though the rates adjust, the profitability of the underlying companies might not look too hot if rates keep going up at 75bps every meeting. Again, those yields certainly look juicy, but be careful with the Mortgage REITs!

Update 7/7/2022: Also check out my buddy Spintwig’s Fixed-to-Float Dashboard: https://spintwig.com/mreit-preferred-share-dashboard/. He’s done a lot of research on the REIT Preferred Shares.

9: Real Estate

Historically, real estate has been an excellent inflation hedge. No surprise here, because a big chunk of the CPI consumption basket is rent: both actual rentals and owner-equivalent rent. Specifically, the “Shelter” category in the CPI is 32% of the overall CPI and 41% of the Core CPI, according to the BLS. And rental inflation is certainly strong, see the recent Wall Street Journal article on renter bidding wars. So, even if the home price appreciation might have plateaued in many places, at least the rental income cash flow will keep gushing at increasing rates.

Talking about real estate, I always have to address the issue of physical real estate vs. REITs. I prefer the direct real estate investment route. Since I don’t want to manage rental properties myself, I outsource the “dirty” work and invest in private equity funds instead, currently at Reliant Group. Broad REIT ETFs (iShares USRT and Vanguard VNQ) have experienced roughly the same drawdown so far this year as the broad market. It appears that the past appeal of REIT ETFs is now reversing as yields are finally picking up, as investors who have previously sought higher dividend yields are now dumping their REITs again. I’d stay away from REITs right now, even though some financial “experts” say that REITs are just as good as brick-and-mortar real estate investments.

10: Short nominal long-term bonds, long floating rate

I saved this one for last because it’s likely only suitable for experienced finance pros and the geeks. The idea here is that if you predict that rates go up faster than everyone else believes, then you arbitrage this through borrowing in a fixed-rate loan and investing in a floating-rate asset. If you were a “Big Kahuna” in the finance world, say a hedge fund or other large institutional investor you could do that very easily with an interest rate swap. Pick how many billions of dollars of exposure you want and contract that swap with a large investment bank.

For the rest of us with 6 or 7-figure portfolios, it’s a bit harder to accomplish that. But not impossible. We could certainly borrow at a fixed rate relatively close to the Treasury interest rate, using the technique I described in a post last year (“Low-Cost Leverage: The “Box Spread” Trade“). Currently, we can do so up to December 2026 (~4.5 years). And then invest the proceeds in a floating-rate preferred share.

The advantage of the box spread loan is that it’s fully tax-deductible, i.e., much preferred to your mortgage or HELOC where you’d need to generate a lot of interest expenditures before you even get over the hurdle of the standard deduction, i.e., before itemization on your tax return makes any sense. And the cost is deductible as 60% long-term and 40% short-term losses. So, if you can find some preferred shares with tax-advantaged dividend income, like the PNC PRP at about par that’s paying LIBOR+4.068%, that would be a nice play. Even in the worst-case scenario where the LIBOR goes back to just above zero, you’ll still make enough income to pay for the loan interest. And if rates were to go up that would be even better!

11: Honorable mention… Options Writing

Most regular readers should be familiar with my work on put options writing. The options strategy is up for the year so far. Not a bad deal considering how bad markets performed during the first six months. But admittedly, my performance was not as good as in 2019, 2020, and 2021. But with all the headwinds that’s still OK. The reason I include this only as an honorable mention is that the strategy is not really an alternative to bonds. That’s because the options trading is done on margin. Writing put options is not a substitute for a bond portfolio. It’s an add-on to an existing portfolio you already have, whether you keep your stocks + nominal bonds portfolio or replace bonds with a TIPS ETF or a floating-rate preferred share.

Notably absent

Here are a few asset classes that may not work very well in the high-inflation environment followed by a Paul Volcker 2.0 scenario:

  • Crypto: Talking about correlations that suddenly switch. Crypto went through the same trouble. Back in the old days, it was heralded as a high-return asset with zero correlation to equities. Now crypto has much higher correlations and especially betas with the stock market, see my post “Crypto is probably a bad investment!” from a while ago. Due to the increased correlations, crypto will no longer diversify your portfolio, but likely add more risk to it. Of course, this works both ways: if inflation is all just a big nothing-burger, the economy avoids a recession, and the stock market rallies again, then crypto assets will likely pick up some of the tailwinds as well. But in the worst-case scenario, I’d expect Bitcoin & Co. to get hammered even worse than stocks and (nominal) bonds. In the two months since the publication of my blog post, Bitcoin is down over 50%. #ToldYouSo!
  • International stocks without an FX hedge: If the Federal Reserve is forced to raise rates much faster and much higher than currently anticipated, we will likely see a strengthening in the USD. So, as I mentioned above, if you like non-US stocks it might be wise to hedge the FX exposure.
  • Preferred shares with fixed rates: what’s worse than a 10-year nominal bond getting hammered by a duration effect? How about infinite-horizon fixed-rate preferred shares? They will have an even worse duration effect. That’s another reason why I stay away from the major ETFs (for example the iShares PFF) for preferred exposure because they have heavy exposure to those fixed-rate preferred shares. With the predictable result that PFF had a drawdown comparable to the equity market this year! In fact, too many of the floating-rate preferred shares in the PFFV fund are still years away from going floating, some of them in 2029 or beyond. Those shares might not be enough of a hedge against short-term rate hikes.


The 40-year-long bond bull market has finally come to an end. What a great run, riding down the bond yields from their 1982 peak all the way to essentially zero in the year 2020. Now we might have an updraft in yields again and safe government bonds might no longer offer as much of a diversification benefit as in the 2000s and 2010s.

If you’re still years away from retirement you might not even need any derisking. Again, refer to my classic post on pre-retirement glidepaths (SWR Series 43) from last year, justifying 100% equities through most (maybe even all) of the accumulation phase. But if you’re close to retirement or in retirement you will likely want to tread a little bit more cautiously than with a 100% equity portfolio.

There isn’t a one-size-fits-all solution. I’m still heavily invested in U.S. equities (#5) and for diversification, I use real estate (#9) and floating-rate preferred shares (#8), even with a little bit of leverage (#10) and some options trading on margin (#11). But I hope I offered a few new ideas for everybody else.

Thanks for stopping by today! Looking forward to your comments and suggestions!

Title picture credit: pixabay.com

88 thoughts on “Hedging Against Inflation and Monetary Policy Risk

  1. As an investor based outside the US it is great to finally pick up some VTI again at lower prices and not hedge the FX risk so I get exposed to USD movements too. Sadly my currency dropped almost as much as the S&P so I’m actually not getting that much benefit.
    Should’ve DCA’d into USDs first! But who likes holding a bunch of cash in a former bull market.

    Anyway, I guess we just keep accumulating plus income diversification (RE and prefs.)

    1. Thanks for sharing. South Africe, I assume? Emerging Markets often see their currency depreciate against the USD if the economy turns sour.

      Yes, DCA is the solution and takes the motions out…

      1. Indeed – it’s tricky since you have instances where the swing is from R5/$ to R10/$ back to R7/$ and now at R16/$ all in the space of 10 year rolling periods. A difficult balance since you want to protect your wealth against currency devaluation, while also living off that currency – so a weak USD during retirement can be problematic. A steady linear depreciation of 4%-6% pa would be so much simpler, than the panicked swings you see =).

        It does give you opportunity to buy USD cheap every now and again, and to benefit from wild mismatching when you’re in the de-accumulation phase. Problematic during accumulation since your salary and savings are affected, but DCA anyway.

      2. How does the 9.1% CPI number change or advance any of the ideas above. I am inclined to see this as conformation of the need to aggressive raise rates (Taylor rule)? How does this change your out look?

        1. Well, maybe the July energy price readings will cause that CPI number to be more moderate again. I’d expect a marked down move in the YoY number.
          I agree, that’s just a one-time adjustment. Nobody in their right mind would call the war on inflation won. But it’s a start. I see the FFR going up much more than people expect now. At least 4% at the peak next year.

      3. Sehr geehrter Herr Big Ern,

        vielen Dank für Ihren ausgezeichneten Blog – immer informativ, immer toll zum Lesen. Besonders Ihr Beitrag “Who is afraid of a Bear Market” hat mich erschrocken und war gleichzeitig unglaublich lehrreich. Ich würde mich über eine Fortsetzung/Aktualisierung sehr freuen.

        Vor kurzem las ich das Buch von Ray Dalio – The Changing World Order. Dabei habe ich mich gefragt, ob bzw. wie sich ein Verlust des Reservewährungs-Status der USA/des Dollars auf ein US-fokussiertes bzw. auf ein internationales Wertpapierdepot auswirken würde? Wie wären die Auswirkungen auf Personen, welche z.B. in 15 Jahren in Pension gehen möchten oder auf Personen, die sich bereits in Pension befinden?
        Vielleicht eine neue Idee für einen Beitrag?

        Freundliche Grüße
        Johanna K. (Österreich)
        Englisch: Lesen: ok, Schreiben: Nein 🙂

        1. Thanks for your kind words! My answer is in English, so others can enjoy it too.
          The question again is: what happens if the USD loses its role as the global reserve currency?
          The answer has two parts:
          1: I don’t even believe the USD is losing its role as a global reserve currency. The Euro is weak due to political and economic instability in the Eurozone. China is having trouble due to its sinking real estate Ponzi Scheme. Britain shot itself in the foot with Brexit (not that the GBP would even rival the USD as a reserve currency anyway). Crypto will not take over as a reserve currency either due to the extreme volatility and all the scandals and scams. The US central bank is ahead of everyone else in raising interest rates. If anything, the last 2 years have cemented the dominance of the USD over the other competitors.
          2: Even if the USD is no longer the reserve currency, the USA will still remain a global safe haven for assets. In other words, maybe central banks across the world will no longer hold as much USD as reserves, but investors will. Where else would you put the money when the
          But you’re right, if that #2 point ever goes away, that would be a scary scenario. I don’t see that happening anytime soon.

          And yes, I should also update that Bear Market post from 2019, now that we have 2 more events! 😉

          Viele Gruesse zurueck nach Österreich.

          1. Danke für die schnelle Antwort. Ich freue mich schon sehr auf das Update “Bear Market”.
            Und ja, im Moment ist der Euro wirklich keine ernsthafte Alternative – schmilzt wie Schnee im April in den Alpen. Aber wir arbeiten daran 😉
            Grüße in die Staaten!

  2. Thought provoking post ERN, thank you. It’s going to be interesting to see how the bond market reacts when rates go up, but there is no more QE to turn off now. I’m guessing that the decline will be less now that QE pump is off and that drop is complete.

  3. I’ve been meaning to comb through your archives on this very topic and yet here it is…in my inbox this morning!
    Outstanding post.
    I need to investigate 8: Floating-rate Preferred Shares…not sure if the bump in yield is worth the time I’d need to devote to pull that off ‘safely’.


  4. I think the question is still whether we have a monetary policy problem or a commodities shortage problem. The GSCI and CRB commodities indices have been plummeting since early June, and crude oil just fell below $100/barrel. Thus, June will have ended up with about the same average commodity prices as May – the first period of declining commodities prices since April of 2020, and a price cut comparable to March 2020!

    Therefore, I have a relatively clean hypothesis test: If June CPI is higher than May CPI, I will call it a monetary policy problem necessitating a Taylor Rule solution and run for my life. If June CPI is lower than or equal to May CPI, I can point the finger squarely at commodities as the cause, and also note that supply chains seem not to be able to pass along all their labor cost increases because consumers are tapped out. This later scenario resolves itself as speculative money flees commodities in anticipation of higher rates, inventory liquidations, and recessionary demand destruction (maybe that’s already occurring?). Maybe this is why bond markets are pricing in 5 year inflation breakevens several percent below current inflation?

    In the later scenario, those who piled into floating rate assets, cash, and TIPS/ibonds would be feeling the regret, would they not? Of course, given the choice between risk of regret versus the risk of being wiped out, I might prefer to risk feeling regretful. Still, this sounds like the setup to every market recovery in history that was missed by investors with easy access to a “sell” button or other hedging opportunities.

    If the market sees a meaningful downward move on inflation, the race will be on to get into beaten-down growth stocks.

    1. No, commodity price are still up June/May. You gotta use the monthly average not the June30/May31.
      But we will record a significant decline in July. So, we may see another scary Y/Y number in July before the big drop in July.

  5. Another great post Dr K!

    I prefer to split the difference with the fixed and FTF (fixed-to-float) shares. If, for example, I allocate 20% of my portfolio to preferred shares, 10% would be allocated to fixed and 10% would be allocated to FTF. The premise is that I have no idea what the market will do, so I spread my bets. If rates continue to climb, then the FTF shares will continue to yield more / trade closer to par. If rates are cut, then the fixed rate shares purchased below par will pop, offsetting the losses FTF shares are expected to experience.

    Also with the preferred shares, my allocations are exclusively mREIT companies for a few reasons:

    >The issues are all cumulative in nature. Regulation prohibits cumulative provisions for bank pfds if the issue is to be used to satisfy capital requirements. With cumulative policies, any pauses or suspensions of the preferred dividend causes the payment to accumulate; there is no skipping payments.

    >With mREIT preferreds, the underlying portfolios can be free of credit risk (agency MBS). AGNC is the pure play for this. NLY and TWO have 70% or more allocated to agency MBS which is enough to have it classified as agency. The offset for having no credit risk is prepayment risk. There are of course other mREITs that focus on non-agency MBS in which there is indeed much credit risk.

    >There’s a third type of mREIT called “originators and servers.” They have portfolios of MSRs or mortgage-servicing rights. Servicers tend outperform their agency and non-agency peers when rates rise since they tend to get a larger slice of the servicing “strip” of the mortgage and don’t have the debt / hedging balancing act happening on their books.

    >Speaking of book value, I only allocate capital to those with ample common equity in front of the preferred shares. Using the ACR-C example from the watch list (#8), the ratio of market cap to pfd liquidation value is 0.32. Said another way, the value of all the outstanding shares is roughly 76M while the liquidation value of all the preferred shares is 235M. Similarly, shareholder equity to pfd liquidation is 0.88%. This is ignoring the negative TTM EPS. If this company more than sneezes near their terminal, they will be suspending preferred dividend payments. In contrast, NLY has a market cap to pfd liquidation ratio of 6.30 and shareholder equity to pfd liquidation ratio of 6.44. They have a LOT of equity and common share “buffer” that serves to insulate the preferred share dividend / cash flow.

    I keep a comprehensive dashboard of all the mREIT preferred shares, along with full write-ups on the formulas and calculations, at https://spintwig.com/mreit-preferred-share-dashboard/ This should help those looking to add this asset class to their portfolio. I target around 20% allocation to mREIT pfds and am currently around 15%, looking to add more fixed rate shares to balance out my floating-heavy allocation.

    1. REM, the etf that tracks those kind of mortgage real estate funds like NLY and AGNC (its top two holdings) that you mentioned is down 33% over the last 15 years since its inception in 2007 all during an overall growing real estate market. In 4 of those 15 years, the fund had drawdowns of 20% or more and one 70%+ drawdown from 07-09. In comparison, the largest preferred stock etf (PFF) was up 68% over the same time period with less volatility and smaller drawdowns.

      Obviously after the fact you can cherry-pick certain mortgage reits that did alright to try make the historical returns for mreits look better but that gets into the stock picking category that’s difficult to replicate going forward.

      Not the kind of asset class that I’d touch!

      1. Well, that’s the common equity. Preferreds will likely do a little bit better.
        Also note the pretty substantial dividend yield. So, part of the dividend yield is really equity liquidation.

    2. Thanks! You’ve obviously done a lot of research on the REITs. I included the preferreds from your watchlist, but only those with common shares that have solid fundamentals, i.e., a decent PE.
      I certainly hope that all of those REITs hold up well during a potential Fed apocalypse. But thanks for confirming that these risky looking REITs are actually quite solid.

      I also don’t put too much weight on the cumulative vs. non-cumulative issue. I think that WFC etc. will be good even if we have a recession.

      1. I updated the dashboard with some additional mREIT issues since the last public version was released, updated the structure and added new columns to provide additional clarity and insights, and added nearly all the companies from your watch list along with some sister shares that weren’t on yours (eg: KEY-J and KEY-K).

        Data as af 4:00pm ET 2022-07-15

            1. There are interesting. I have a few of the BoA Preferreds of this type. A very low LIBOR spread (~0.75%) but a 3.75-4% minimum. Looks like an interesting hybrid. During low-interest periods you have effectively a fixed-rate preferred. But some hedge in case interest rates go wild. I also like the steep discount, trading at around $19-20 for the $25 notional.

              1. Precisely the reason I opened a few positions at prices in the 18s and 19s.

                >Yield is >5% for both issues.
                >If/when FFR is lowered, it is anticipated that share prices will approach their ZIRP values as FFR approaches zero.
                >Since the shares have a 4% ($1.00/share/yr) floor, yield can’t be any lower than it is today.
                >If/when FFR is hiked such that spread + FFR is above the floor, divs/yield will increase.
                >If/when shares get called, there’s over 20% capital appreciation baked in which provides lots of potential upside in various scenarios.

                It’s essentially a long strangle on interest rates – buying a >5% YOC floor for as long as these two banks decide to keep these shares outstanding and remain solvent, and get to ride the yield up if FFR + spread > floor.

                I’ve got my eye on some others as well.

  6. REM holds common shares, not preferred shares. The risk profile and mechanics between these two share types is completely different. Common shares have exposure to book value / equity while preferred shares are only exposed to the cash flow of these companies.

    I don’t think anyone has suggested investing in mREIT common shares. This is all in reference to #8 from BigERN’s list (preferred shares).

    1. PFFR holds preferred reits and hasn’t had great performance (0.89% CAGR) either since its inception 5 years ago.

      1. PFFR holdings are mostly eREITs (i.e. equity [traditional] REITs), not mortgage REITs.

        I’m not aware of an ETF that’s exclusively mREIT preferred shares.

        Either way, performance can likely be materially improved by selecting companies that have strong balance sheets (eg: NLY pfds) and avoiding those that don’t (eg: ACR pfds).

        For context, BND’s CAGR was 1.07% over the same period, slightly outperforming, but it had a lower Sharpe ratio.

        Source: https://www.portfoliovisualizer.com/backtest-portfolio?s=y&timePeriod=2&startYear=2017&firstMonth=1&endYear=2022&lastMonth=12&calendarAligned=true&includeYTD=false&initialAmount=10000&annualOperation=0&annualAdjustment=0&inflationAdjusted=true&annualPercentage=0.0&frequency=4&rebalanceType=1&absoluteDeviation=5.0&relativeDeviation=25.0&leverageType=0&leverageRatio=0.0&debtAmount=0&debtInterest=0.0&maintenanceMargin=25.0&leveragedBenchmark=false&reinvestDividends=true&showYield=false&showFactors=false&factorModel=3&portfolioNames=false&portfolioName1=Portfolio+1&portfolioName2=Portfolio+2&portfolioName3=Portfolio+3&symbol1=BND&allocation1_1=100&symbol2=PFFR&allocation2_2=100

        1. PFFR still holds 35% mReits, so it’s as good of a proxy of an index for these as I could find.

          In this context of hedging against inflation, BND isn’t a great benchmark to use. Something like VTIP which has had 2.7% CAGR and 0.79 Sharpe Ratio over the past 5 years would be a better comparison.

          NLY pfds have had decent returns but MUCH more volatility such as 60%+ drawdowns in 2020 and would’ve been worse in 2007-09 so their risk adjusted returns aren’t so great.

          1. All good points.
            My personal rationale for adding some of the mREITs and Bank F2F Preferreds:
            2008/9 was a deflationary banking crisis and housing crash. 2022 will be an inflationary mild recession, hopefully without a housing market crash.
            2020 was a crazy crash with a liquidity issue where people threw away everything even remotely risky. I don’t think that will repeat either.
            But I could be wrong! 😉

            1. There’s certainly great chance that any kind of corporate debt might not tank as much in future crises after how accommodating the fed showed it could be a backstop on 2020.
              I do agree that residential real estate should hold up alright as long as the fed doesn’t have to raise rates more than is currently expected but I could see corporate real estate continue to take a beating as more of the multi year leases continue to expire and a lot workers still don’t have any desire to go back to full time in the office.

  7. I feel I am missing something major, but aren’t TIP ETF yields NOMINAL?

    Where/How can I get TIPS at a REAL rate of 1%+?

  8. Thanks for this article. This is really a difficult and confusing time. The way we have done things over the last ten years looks to be changing, and thus we must educate ourselves on strategies beyond the buy and hold path that has worked so well.

    Some ideas to share that I have done in 2022:
    1. Consider taking capital losses, especially on bonds. Buy back in 2-3 months.
    2. Evaluate your equity exposure. Don’t sell at this point, but do write down how you are feeling. A future note to yourself to read when times are better.
    3. Build cash reserves. If you are younger, maybe just keep plowing money into the market. If you are closer to retirement (I am) just let those cash reserves build (for now).
    4. Read up on active strategies. BigERN options is one. Simpler might be trend following, which Todd Tresidder favors. I do believe that we are in for a more difficult stretch, and I think it’s prudent to up your investment game by finding a methodology that makes sense to you and deploying it in a chunk of your portfolio.

    Good luck! Stay frosty out there, it’s just getting interesting.

    1. Yes. All good points.

      And thanks for the endorsement of the options writing strategy! Hasn’t worked as well as in 2021 but it’s still one of the few things that can make money in volatile times! 🙂

      1. I would be curious on your thoughts around Tactical Asset Allocation.

        The idea of a strategy or strategies that blends consistent returns while avoiding large drawdowns and only trades once a month is particularly appealing to me at my older just about to fire stage in life.

        1. TAA , if you can make it work, would be the holy grail.
          Most unsophisticated investors and “experts” rely solely on momentum/trend-following to do so, but that’s not a reliable strategy on a standalone basis.
          But if you can add some additional factors and signals, that would solve the drawdown problem, yes.

  9. In s.9, Real Estate, you say: “Since I don’t want to manage rental properties myself, I outsource the “dirty” work and invest in private equity funds instead, currently at Reliant Group and Imprint Property Group (formerly known as Drever Capital Management).”

    Do you have any further details on these types of investments and how we can invest in them, minimum limits etc? I went to their websites, but there was no way to invest with them (listed on the website at least). Thanks!

      1. Just wondering, how did you go about finding them/vetting those kind of funds. I see they’re both based in the bay area so did you have some kind of connection there?

        1. Personal connection. The two ladies who ran the investor relations at the respective companies at that time are good friends. They have since left, but the companies are still solid. 🙂

  10. Hello Professor. You have said in past posts that you are targeting a premium of $1.00 per SPX. Which corresponds to 0.025% of spx (at a price of $ 400,000). And what happens if in 5 years the SPX doubles to $800,000. Will you also focus on the $1.00 premium or will you switch to $2.00 to match 0.025%?

    1. Right now I am targeting a premium of $0.70 per trading day (and closer to $1.00 over the weekend).
      I will see how I shift this if/when the index moves higher. I might sell fewer contracts at a higher price. Or keep the premium target as is. I will make that call when the time comes. 🙂

      1. Why exactly $70 for a training day and $100 for over the weekend? Why not $120 or $50 per day? I would like you to share why exactly this amount? What is the mathematical meaning?
        In one of your posts I saw that you just target 4-5% to your portfolio with 60% capture options premium. But in 2021 you showed an 8% return on this strategy.
        It’s just that when you usually sell delta 5, it seems to me that at times when the market is falling heavily, the premium, though, rises and the smile stretches down, but not strongly enough, as in your case. In your case, when targeting premiums, the lower edge moves very far away, and also comes very close when volatility is at a low level. This method is more universal than the banal delta 5. It seems to me that you are simply setting yourself the task of earning 5 percent from this strategy when capturing a 60% premium. Am I right? Or you have some mathematic inside that choice (70$ and 100$)?

        1. I don’t think we try to hit fixed delta, but certainly something to watch.

          SPX price * 100 * 5% = weekly put income

          Weekend acts like 1.5 days and all others are 1 day, so Friday sale is 1.5 times the other days.

          When IV is really high (likely recent drops), I’ll look for a little more premium on Put sell. Also, when big events are happening, I’ll take a little less premium (lower delta).

          I certainly pay attention to IV * Delta to not grab too much risk.

          1. Thanks!
            What I like about the fixed premium is that you automatically scale down risk when vol is high. But I do scale up the premium when things get really crazy like in March 2020. Even 2x the premium still seemed far enough OTM at that time.

        2. There’s no exact science. It’s a tradeoff between the number of loss events and the intensity of loss events. You can trade fewer contracts with a larger delta or more contracts with a smaller delta. to generate a fixed amount of revenue.
          This combination I’m currently using has evolved over time. The correct one, $70/day, $100/weekend works for me.

  11. U.S. is the largest economy…fear nothing…China is closing in fast and you won’t have this problem anymore

      1. worked with international stats much of my career

        lots of official government stats ex-US are ‘gamed’

        why i don’t invest in developing countries…don’t trust the numbers reported by companies there who are heavily controlled by the state.

          1. That might be but GDP is not the only indicator I look. Check their progress in weapons and space. It’s light years ahead of the US. Many scientists now are betting China will be the first to set foot on mars. Imagine how embarrassing that will be for the once mighty US. Anyway let’s watch how it plays out

              1. In 1989 China’s GDP per capita was about the African average or a third that of Latin America. Do you really think there was no development since then, or just that recent development is overstated to some extent?

                The photos I receive from my Chinese acquaintances of random streets in secondary cities, they look like Europe in terms of capital level and considerably cleaner and better maintained in practice. Nationwide shinkansen network that they appear to ride as they like, and are not particularly rich people. Development does not look fake to me. Maybe rural areas don’t share this level, but then it’s not like rural America does either.

                Perceptions of the CCP as “communist” have “evolved” over time. Back when they were wrecking their economy with actual communism, they were in fact quite well regarded in the Western media. Mao got many nice obituaries. In the mid 2000s, when they long since stopped being communist and were reaping the rewards, the Western press started attacking them relentless for “inequality in development.” Now, today, that there is essentially zero absolute poverty in China for the first time in history, Western press once again calls them “communist” but now it’s meant to be a bad thing…!

                1. Don’t disagree with anything.

                  CCP moved from being communist to fascist. Hence the clean cities (=”trains run on time”).

                  If Karl Marx were alive today, he’d be appalled by the conditions of Chinese factory workers. Conditions are more like in 1800s Manchester. Workers in capitalist economies have it better, even Karl Marx would admit.

                  Not being Communist doesn’t make China any better. It’s a fascist and militant regime, that figured out that Soviet-style economics doesn’t work, so they outsourced the business side to the oligarchs (like under Hitler). Oligarchs are under strict party control. It will certainly delay the collapse. Let’s hope they don’t blow up the world with them.

  12. I moved a lot of my cash into the VRP variable rate fund in order to catch the rising rates effect but that fund dropped as mush as the stock market and now I’m sitting with a huge loss. I wonder why that happened. Do you know and should I wait out or sell at a loss now and harvest it?

    1. VRP and some others still hold a a lot of Preferred shares that are not yet floating but will eventually go floating. That and the deterioration of risk appetitive, and expanding credit spreads took down your fund.

      My prediction is that they will all come back again once the economy comes back.

      At least do some tax loss harvesting.
      You could do a swap to another floating rate fund (or just buy the underlying yourself and save the expense ratio).

  13. Hi ERN,

    With the yield curve flat/inverted, is it a no brainer to switch to shorter bonds? (Closer to cash, like you recommend in your article?)

    If I can get the same yield on a 2Y as a 10Y T-Note future, wouldn’t I be an idiot to hold a 10Y right now?

    Even better I hold twice as much 2Y and benefit from double yield with less duration risk?

    Not to mention, when the curve eventually steepens again, that means 2Y yields dropped or long yields rose, which would mean higher 2Y bond prices?

    Seems too good to be true. What am I missing here?

    Thank you,


    1. It’s no free lunch. You can hold a 2Y at a higher rate. But what happens after 2 years? What if the 2Y rate is back to 1.5%. You would have been better locking in the 3% for the entire 10 years.
      In contrast, what if the Fed goes completely bonkers and we have a crazy inflationary decade ahead of us? You’d be better with the 3% in a 2Y and then get 5% or 10% or more on the subsequent 2Y bonds. Then the short-term bonds are better.
      Which scenario is more likely to you? That determines what bond to hold.

      1. I remember back in early 2019 when the yield curve previously inverted a lot of financial “experts” suggested to not lock in the same long term rates (~2.5%) that they could get from short term bonds that had more flexibility. It turned out to be pretty poor advice as we all know yields collapsed in 2020-2021 and they would’ve missed out on 3 years of 2.5% yields.
        Who knows what will happen this time though…

  14. Hello ERN,
    I admit I’m a bit confused here. I’m close to retirement and holding my assets in the default allocations of your Safe Withdrawal worksheet (by that I mean a Vanguard 500 index and a 10 year treasury index). Calculated my safe withdrawal rate about a year ago, before the current downturn, and now I am reading here about alternative ways to approach the market in this particular downturn. My question is, then, as this is not yet the worst investing environment in the history covered in your SWR calculations, can I continue to rely on the safety of my asset allocation and withdrawal rate?

    1. Yes, you can stick with the standard allocation. As I said, the 1970s/80s were worse than what we’re going through.
      But we can certainly wonder if there are better allocations outside the standard 75/25…

  15. With respect to ibonds and tax efficiency, you know they are tax deferred, right. Save retirement/roth space for stocks.

  16. What about commodities in general? I read an interesting suggestion that a Long Commodities (they suggested DBC ETF) / Short Treasuries (TBT ETF) has offered pretty positive returns, lower volatility, and hasn’t required “perfect timing” to execute. But I don’t really have the data analysis/simulation skills to investigate that claim further.

    Thanks again for another informative post!

  17. Hi Big ERN,

    I’ve been following your blog for years, thanks for all the really valuable work you put out there!

    My biggest problem is not to find/define a personally suitable investment/withdrawal system but rather the psychological side of it.

    How do you deal with regime changes as discussed in this article or with another gutwrenching crash like 2000 or 2008? Simply trust the system?

    (As I understand your options writing somewhat provides a cushion but due to lack of financial knowledge that is not an option for me.)

    What about developments outside of the system? E.g. for example you invest your assets in the U.S. which has been very successful. But will the geopolitical/-economic situation change in the next 30-60 years? After all the sample size (basically the last 70 years) is actually not that much larger compared to the projected retirement period.

    Do you have any hints for me or point to anybody from the FIRE community, book, … that discusses such issues?

    Thanks again for all your work!


    1. Thanks!
      I’m a financial economist, so I don’t deal with psychology.
      If you found 2008 gut-wrenching, 1929-1932 was even worse. And the SWR generated with historical data survived the Great Depression. So, there’s the psychological assistance: use data. That has always calmed my nerves. People who need additional “motivational speaker”-style help, should listen to some of the other content creators in the FIRE community.

      We got data for the US for 150 years. I don’t forecast the exact path over the next 30-60 years, but I doubt that the *distribution* of random returns will be materially different in the future.

    1. I don’t really hold enough cash to stress out about that. I checked on Yahoo finance and for some reason it has a dividend yield of only 2.3%. if that’s true, considering that the fund lost quote a bit (price return), it’s not an adequate cash alternative.
      But, again, maybe the Yahoo Finance dividend yield is incorrect.

  18. Hi Karsten,

    I’m interested in your presentation of gold as theoretically enhancing SWRs.

    My own research has concluded that the uncorrelated nature of gold and its strong returns during some of the worst periods for stocks make it worth considering at around a 10% level for decumulation portfolios.

    I’m also curious if you have looked at utilities as a prospective asset class. They have a strong performance this year, are fairly recession proof as publicly traded companies go, have a long track record of solid returns, and are decently uncorrelated with the broad stock market.

    1. All good points. I present the facts here about gold, but haven’t felt confident enough to put 5-10% into that asset class.
      If I ever do so, I’d do it via gold futures, not gold ETFs, though.

      I like utilities. But I’m not into stock picking and not even sector picking. As an index fund investor I already have some exposure. Not sure I should sell my index funds and buy more utilities.
      But I have some utilities preferred shares in my options trading account. They did OK. But again, to make a difference in the overall allocation, I’d have to plow $0.5m to $1.0m into utilities. Not comfortable right now.

      1. After much wailing and gnashing of teeth I have finally moved from 100% equities to 80% equities. Not at a market high and not when completely comfortable with the alternatives but because there may never be a good time in terms of both valuation and motivation to deal. I considered Gold which looks very good historically (see above and https://www.allianzgi.com/-/media/allianzgi/globalagi/editorial/navigating-rates/portfolio-risk-mitigation-without-bonds/allianzjpmmas22portfolioriskmitigationwithoutbonds.pdf).

        My worry with Gold is that as great as it looked in periods like the 1970s that the effects of Bretton-Woods, suppression of private US trading in gold, AND allowing US citizens to buy Gold from 1974 could make the historic models poor analogues for the situation today.

        I considered a split of Gold and TIPS but ultimately I have insufficient confidence in Gold to be certain I can hold it through the inevitable volatility.

        So I went with 0-5 year TIPS ETF unhedged to my local currency (GBP). I lack the ability to model 80% MSCI World 20% TIPS but am accepting FX volatility in return for an expectation that the reserve currency nature of the USD means that FX will move the right way when I need it most.

        I am not a US investor and invest in global equities although the last 100 years would have been best in US equities. Think of this as diversification against US political instability.

        Please critique my approach and if I have got this totally wrong feel free to suggest a more cautious allocation that should withstand inflation and recession. I am at the start of the decumulation phase.

        1. Thanks for sharing.
          100% equities will do OK in the accumulation phase. In retirement, it’s pretty scary.
          Political instability is everywhere. I think the US is the least dirty shirt in the dirty shirt hamper. EU and UK pose even more political risk, in my view.

          1. Put like that you may be right.

            Perhaps it’s the (cynical) assumptions in my version of your sheet but other models seem to be much more rewarding with lower equity valuations. I have currently settled on 75% MSCI World 20% TIPS Short Duration (USD) and 5% Equity. Lots of historical backtesting has allocations more evenly split like 40/20/20 equity/bond/real.

            Ultimately I’d like to move some of the TIPS into intermediate government bonds but I don’t feel the time is right. I also must confess this is less allocation and more market timing. One thing I am not brave enough to do is bet against the Fed. There don’t seem to be many tools for modeling with TIPS but I guess that’s related to the short history of TIPS (Index linked gilts have been around longer but are extremely expensive, unless events prove otherwise!).


            1. Understood.
              And you’re right, this a great environment for folks if they get the Fed timing right. Once the Fed lowers rates again, it’s time to move back into nominal bonds and ride that rally down. I agree with you: that time hasn’t come yet! 🙂

  19. As far as floating rate bonds funds go — check out USFR at WisdomTree — floating rate treasury bond fund at 15bps cost and a 50+bps pickup in yield vs. money markets. So exact same safety (its treasuries) and better yield than any money fund. BlackRock also has one – TFLO – but its smaller.

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