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Making The Best Of Bonds

With higher inflation, interest rates rise, potentially very quickly. As interest rates increase, conventional fixed-rate bonds depreciate because investors demand higher yields.

From January 1970 through January 1981, when annual inflation averaged 7.8 percent, 30-day Treasury bills returned 6.8 percent. Longer-yielding bonds fared much worse, returning 4.0 percent before adjusting for inflation. Because we believe the chance of a period of high inflation has increased substantially, we have altered our fixed-income strategy to emphasize securities whose rates adjust frequently.

Money market funds offer yields that adjust with short-term interest rates. If the Federal Reserve raises interest rates by 3 percent, yields on these funds will also increase about 3 percentage points. Unfortunately, current yields are low. By late May, taxable money market funds were yielding 2.3 percent. Still, this is the safest and most liquid way to invest and will continue to represent a portion of our fixed-income portfolios.

Floating-rate corporate debt merits a small allocation in many fixed-income portfolios. These non-investment-grade debt instruments are senior to stocks and bonds in a corporate capital structure, increasing the likelihood of a full return of principal even if a corporation has severe financial trouble.These loans frequently offer variable rates that fluctuate directly with short-term interest rates. Thus, their principal will remain intact even while their yields rise with higher interest rates. In May, these loans were yielding 7.37 percent,which was 350 basis points (3.5 percent) above the 10-year Treasury bond.

Overseas bonds can enhance returns if the dollar declines. Several foreign bond funds provide non-dollar exposure and may also increase an investor’s yield, as the debt of many foreign governments currently pays higher interest rates than that of the United States. Of course if the dollar appreciates, the foreign bonds will be worth less in dollar terms, and the investment principal may decline.

Treasury Inflation-Protected Securities (TIPS) are ordinarily a good way to hedge inflation. The principal of these government securities increases with inflation. Also, TIPS pay a small income return, often referred to as the “real return.” However, there are a few drawbacks to investing in these securities. The first is that the inflation measure is keyed off of the Consumer Price Index, which sometimes does not fully capture inflation. The second is that the current real return is a dismal 0.7 percent on five-year TIPS. The third is that TIPS, when held in taxable accounts, are tax-inefficient, as tax payments are required on undistributed income. At this point, we do not find TIPS attractive.

A newly created exchange-traded fund (ETF) tracks non-U.S. inflation-protected bonds offering non-dollar exposure as well as inflation protection. The SPDR DB International Government Inflation-Protected Bond ETF (Amex: WIP) owns government inflation-protected securities in 15 currencies from 18 countries. Currently, the real return is 3 percent, about four times greater than the real returns of TIPS.

Because this investment owns bonds denominated in foreign currencies, the dollar’s strength or weakness will impact returns. If these currencies decline against the dollar by more than their average inflation plus 3 percent (the real return), this fund can be expected to lose value.

If you enjoyed this article, be sure to check out Palisades Hudson’s books, The High Achiever’s Guide To Wealth and Looking Ahead: Life, Family, Wealth and Business After 55. Both are available in paperback and as e-books.