After a decade of not having to worry about inflation, the last year or so has reminded us that the invisible hand of rising prices is alive and well. And as inflation has risen, so have interest rates. The Fed has completely reversed course and entered a period of tightening. For fixed income investors, this has created a very difficult to navigate environment.
But all may not be lost. There are a few ways that bond and fixed income investors can shore up their portfolios and get through the year ahead. And with inflation expectations still predicted to be high and at more normal levels, investors may want to consider the trio for their fixed income portfolios.
Don’t forget to check our Fixed Income Channel to learn more about generating income in the current market conditions.
Inflation & Fixed Income Investments
While inflation has dropped a bit lower from its recent peaks, we’re still looking at historically high inflation rates. The Consumer Price Index (CPI) increased 0.1% in November and is currently running at 7.1%. To combat this problem, the Fed has undergone the task of raising rates. After a series of rate hikes, including three 0.75% jumps, benchmark interest rates now sit at 4.25%. Given the still steady pace of inflation, expectations now have benchmark rates growing to 5.25% in 2023, before dropping in 2024.
For fixed income investors, this has been a major issue.
The problem is that bond coupons are fixed for a period of time. So, as inflation surges and the Fed raises rates, new bonds come to the market at higher coupons. Bonds already on the market fall in price to reflect the new higher rate. It’s a double-edged sword for fixed income portfolios. Not only does your income in real terms fall on the bonds you already own, but their prices decline as well.
Given that expectations for inflation are now running hot, investors in bonds are facing a quandary on how exactly to best fight these current and future conditions. The answer may lie within a trio of specialized bond varieties that when used together are designed to provide current inflation protected income as well as future income protection as well.
Inflation Protected Income Today
Given that inflation is running hot today, investors need a way to protect their current spending from rising prices. Floating Rate Treasuries and corporate bonds could be the answer. Dubbed “floaters,” these bonds feature coupon rates that are tied to short-term benchmark rates. In the case of Treasury-issued floaters, the rate is tied to the latest 13-week T-bill auction and resets every week. For corporate debt, coupons have historically been tied to the London Interbank Offered Rate (LIBOR). However, with LIBOR being retired, many current issued floaters have used the Secured Overnight Financing Rate (SOFR).
So, as the Fed raises rates, the coupons on floating rate bonds will move higher. This immediately increases the amount of interest they pay to their investors. Another positive for floaters is their lower volatility. Because their coupons can and do change, investors tend not to sell them when rates rise to buy newly issued, higher coupon bonds.
Buying floaters is easy. Most brokerages offer the ability to purchase them directly, while the U.S. Treasury via TreasuryDirect allows investors to buy them for as little as $100. There are also several ETFs and mutual funds that follow the asset class. For example, the iShares Treasury Floating Rate Bond ETF (TFLO) and iShares Floating Rate Bond ETF (FLOT) offer exposure to treasury-only and investment grade corporate floaters, respectively.
Inflation Protected Income Tomorrow
Floaters make sense for investors needing inflation-protected income in the here and now. But what about tomorrow? Well, fixed income investors do have some choices to help them and they come from the U.S. Treasury. We’re talking about I-Bonds and Treasury-Inflation Protected Securities.
After being ignored for the better part of a decade, I-Bonds recently have become in vogue with investors after offering a massive 9%+ yield. While their rates have dropped to just below 7%, they still offer a valuable tool for investors. That’s because they can be used to push inflation-protected cash into the future.
As a zero-coupon bond, I bonds’ interest is added back to the bond and compounded until you sell the savings bond back to the Treasury. That interest is calculated in two ways. First, via a fixed rate that stays with the bond for its interest-earning life – currently 30 years. Second, the securities feature a semi-annual variable rate that changes with fluctuations in inflation. The combination allows investors to outperform inflation over the long haul. The best part is that interest can be tax deferred for 30 years.
Buying I bonds can be a bit cumbersome, however. Investors must buy them from the Feds via TreasuryDirect and are limited to just $10,000 per year, per taxpayer. You can get an additional $5,000 in I bonds as a tax refund.
TIPS are another way to protect a fixed income portfolio from inflation over the long haul. But they can be confusing. Like I Bonds, TIPS are zero-coupon bonds and have their fixed interest added/compounded back into the bond until they mature. What is weird about them is that their principal/face value adjusts based on changes to the CPI. And therefore, the amount of interest investors receive, based on the fixed coupon, can rise. However, during periods of deflation, the inverse is also true. When the bond matures, investors would receive either the adjusted higher principal or the original principal value as well as all the interest accrued.
Buying TIPS is pretty easy. Both TreasuryDirect and brokerages allow for individual purchases, while there are numerous ETFs and mutual funds that cover the bond type.
Putting It All Together
The combination of using floaters, TIPS and I Bonds in concert with each other can provide a powerful inflation-fighting sleeve to a fixed income portfolio. Here, investors can have rising income for today as well as push inflation-protected cash and a real return element into the future. When coupled with more traditional fixed income assets, the inflation sleeve can provide just what investors need in the current environment.
Take a look at our recently launched Model Portfolios to see how you can rebalance your portfolio.
