3 Ways to Position Your Bonds for Inflation
Have you filled up at the pump recently? Have you seen the price of Pastrami at the grocery store (if you can even find it)? Unfortunately, our dollars simply aren't going as far today as they were a year ago. The latest inflation numbers showed that consumer prices increased 5.4% from September 2020 to September 2021, and rose to a three-year high.
The Fed has stayed steady with its argument that the high inflation numbers right now are "transitory," stemming from demand imbalances caused by the pandemic, wages that are rising but only modestly, and supply chain issues that will work themselves out. The Fed still expects inflation to ease down toward 2% in 2022, close to their mandate. However, consumers aren't buying that argument. A survey done by the Federal Reserve Bank of New York showed consumers' expected inflation of 4.2% over the next three years.
Personally, I believe the number will be somewhere between the Fed's expectations of around 2% and the Consumer's expectations of 4.2%. It seems likely that price increases due to the supply chain issues will subside. However, I believe other parts of inflation, such as higher housing, rents, and wage costs may be stickier. Regardless of where inflation comes in, there may be some impacts to your bonds.
Impacts on Fixed Income:
Inflation is tough on bonds. When inflation is running higher than the interest you can earn on a bond, you end up with a negative real yield, as we have right now. Making matters worse for bondholders, as one of its mandates, The Fed's goal is to control inflation. One of the main ways it does this is by raising interest rates, causing bond prices to fall.
Think of it this way, if I were to offer you two bonds with the same maturity and quality, but one pays 1%, and the other pays 2%, you, of course, would buy the one that pays more. You would only be willing to buy the one for 1% if the price was lowered. That's precisely what happens in the bond market. When interest rates go up, the prices of bonds go down, and if the interest rate increase is high enough, bondholders lose money. Thus, potential rising rates are one of the biggest risks bondholders face. The Fed is not quite there yet, but it is reasonable to assume that rate increases are coming if inflation stays elevated and unemployment continues to tick downward.
That's a challenging position for investors because we still believe, that bonds provide an important ballast to portfolio volatility even in this current environment. So what can you do to mitigate the impact?
Three Ways to Combat Higher Rates:
LOWER YOUR DURATION
Duration is a way to measure a bond's sensitivity to changes in interest rates. A high duration bond feels a significant impact from a change in interest rates; a low duration bond has a smaller effect. One significant factor, but not the only, is the bond's time to maturity. Make's sense; I'd rather own a bond that pays an under-market rate for just one year vs. ten years. If I held a bond that paid an under-market rate for ten years, I would expect to obtain it only at a very hefty discount. While the yields will likely be lower on low-duration bonds, the impact of rising interest rates will be less.
BUY INDIVIDUAL BONDS AND HOLD UNTIL THEY MATURE
When you buy an individual bond, you know what you are buying it for, the coupon payment along the way, what you will get for it when it matures, as long as the company can make the payment. In that scenario, it doesn't much matter what the market would pay for the bond along the way. The outcomes are defined. This can be especially effective if you regularly distribute money from your investment accounts as you can ladder the bonds around your cash flows. The downside is you lose the diversification benefits of a bond fund or index and pick up risk related to the issuer of the bond. Even so, this can be an excellent way to hedge against interest rate risk.
TIPs (Treasury Inflation-Protected Securities) are securities offered by the government that adjust for inflation. As inflation rises, the principal of the bonds is adjusted upwards, offsetting the impacts of inflation for an investor. That inflation protection comes with a drawback, though. TIPs have an interest that is equal to the Treasury bond yield minus the expected inflation rate. When Treasuries are trading at very low rates (like they are now) and inflation expectations are elevated, it results in a negative interest rate. Right now, a five-year TIP has a yield of negative 1.69%. However, with the inflation adjustments to the principal, you can still make money on it if inflation is high enough. Right now, on October 25th 2021, the breakeven would be a 2.91% inflation rate over five years. It's an option to consider if you believe we are heading to runaway inflation. If inflation ends up lower than 2.91% over five years, you will have locked in a loss, though.
The Bottom Line:
The current environment makes it seem unattractive to own bonds. However, we believe they are still a Valuable part of your portfolio due to the stability they provide and their usefulness in cash flow mapping. Still, given how low interest rates are and how high inflation has been, it may make sense to make some adjustments to your fixed-income strategy. If you need some help evaluating your current investments, we'll be happy to take a look at your holdings and help you employ strategies that can help combat the effects of high inflation on your portfolio. Give us a call at 904-374-9098.
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