Fixed income is an integral part of most retirement portfolios—particularly those that already rely on the income. Unfortunately, with rising demand, supply chain disruptions and wage pressure, the annual inflation rate reached 6.8% in November 2021, marking its highest level since June 1982. And that’s putting pressure on fixed-income portfolios.
Let’s look at some strategies that you can use to protect your fixed-income portfolio from inflation.
Don’t forget to check our Fixed Income Channel to learn more about generating income in the current market conditions.
Shortening Duration
The most common response to rising inflation is shortening duration—or how much a bond’s price changes based on interest rates. For example, a bond with a 5-year duration could lose 5% of its value for every 1% increase in interest rates. The catch is that a shorter duration translates to lower yields, meaning less income for retirees.
A typical retirement strategy is to match duration to anticipated spending events. For instance, you might consider holding a three-year duration if you need cash for a vacation in three years. That way, you can hedge the capital against adverse interest rate movements until you spend it. Or you can ladder durations to spread out risk over multiple periods.
Currently, the 10-year Treasury yield is 1.467% versus 0.27% for 1-year Treasuries. Given the significant difference in yield, it’s tempting to seek out bonds with both higher yields and lower durations. These bonds tend to have higher credit risk, but funds like the Chartwell Short Duration High Yield Fund (CWFIX) can help diversify that risk.
Portfolio Diversification
Bonds are the most popular component of fixed-income portfolios, but there are many other ways to generate income. For instance, real estate investments provide inflation-protected income since landlords can increase rent to adjust for inflation. Real estate also offers certain tax advantages that can improve after-tax returns.
Commodities and other alternative assets also tend to rise in value when inflation rises, offsetting the potential drop in bond prices. In addition, many investors are turning toward cryptocurrencies to provide diversification. However, the biggest drawback of these assets is that they don’t offer any yield, limiting income generation for retirees.
The PIMCO Inflation Response Multi-Asset Fund (PZRMX) holds a portfolio of TIPS, commodities, emerging market bonds in local currencies, real estate and gold to provide all-in-one diversification for any portfolio. The fund also offers an attractive yield thanks to its exposure to emerging market debt.
Be sure to check our Portfolio Management Channel to learn more about different portfolio rebalancing strategies.
Hedging Against Inflation
Treasury Inflation-Protected Securities, or TIPS, are the purest way to hedge against inflation. While the value of these bonds changes with inflation, they can lose money when interest rates rise and inflation expectations fall. The IRS also taxes the inflation adjustment as income, making them expensive in many taxable accounts.
Series I Savings Bonds are an attractive alternative. Currently, these bonds offer a 7%+ annual yield through April 2022, when their inflation adjustments reset. And, unlike TIPS, the fixed-income portion of the bond can never go into negative territory. The catch is that there is a $10,000 limit and certain withdrawal conditions to keep in mind.
Click here to learn more about I-bonds.
The Bottom Line
Fixed income is a central part of most retirement portfolios. With inflation on the rise, retirees could see their portfolio values plummet over the coming year as the Federal Reserve hikes interest rates. Fortunately, there are some actions that you can take to mitigate the effects of inflation and preserve your spending power.
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