It's an axiom of fixed income investing that inflation is a bond holder's worst enemy. But what's an investor who requires regular income to do when the interest rate environment changes, and rising rates and inflation are forecasted? Not only does the investor risk watching the nominal value of his/her bond portfolio diminish, he/she also loses the opportunity to reinvest on more favorable terms as interest rates climb.
TUTORIAL: Bond & Debt Basics
Given that scenario, we've collected a number of underutilized products and strategies that income investors can avail themselves of when the winds of inflation begin to howl.
1. Get Protected
Inflation-protected securities (IPS) offer income investors a popular method of staving off the effects of inflation and rising rates. These securities are comprised of two components, a regular bond coupon that pays a stated rate of interest, and a Consumer Price Index-linked element that adjusts the principal value of the bond up or down with changes in the index. They are offered by the federal government as Treasury inflation-protected-securities (TIPS) while in Canada they're sold as real return bonds (RRBs).
Recently, municipalities and corporations have been offering their own versions of IPSs. These may have tax advantages over federally issued IPSs, but be sure to check with your financial advisor to see that the benefits of these issues outweigh the purchase of higher-rated, federally backed bonds. (Learn more in-depth details about IPSs in our article, Inflation-Protected Securities – The Missing Link.)
Risks to IPSs:
Extended drops in the CPI (i.e. deflation) will erode the principal of an IPS, potentially leaving investors with a negative absolute return.
As with any fixed income investment, the creditworthiness of the issuer is paramount. Best to know who you are buying, and to allocate your funds accordingly.
2. Go Short
Another popular strategy in a rising rate environment is to keep the duration of your fixed income investments short. Shortening the duration of your bond portfolio means you receive cash sooner than longer duration bonds and therefore you can reinvest that cash sooner at higher interest rates in an inflationary environment. Conversely, in a decreasing interest rate environment you may also want to consider extending the duration of your portfolio. By staggering your maturities from between three months to a year – or by simply investing in a prudently managed, money market fund that does that for you – you can safely capitalize on rising interest rates. (Take a closer look at duration in our Advanced Bond Concepts Tutorial.)
Risks of Short Bond Duration Strategy:
This strategy may require you to pay more time and attention to maturing issues and their subsequent reinvestment than you have available. A good advisor (or money market mutual fund) will help with this.
Even with inflation, rising short term interest rates don't always mean similar rises at the long end of the yield curve. Staying "short" might limit some investment gains you would have achieved by maintaining a longer term bond position. If you believe the long end of the curve is stable, consider employing a "barbell" bond strategy in which you buy both short term bonds and long term bonds, but none in-between. This strategy gives you the higher interest rate of the long term bond but also gives you flexibility to buy and sell the short term bonds if interest rates rise.
If inflation is imminent, consider apportioning at least part of your fixed income portfolio toward floating-rate notesand preferred shares. These investments generally yield more than IPSs and money market funds and are structured to increase their payouts as yields climb.
Risks of Floating Rate Securities:
Not all "floaters" are created equal. A credit rating check on the issuer of your floating rate note or preferred share will help determine how much to allocate to any specific issue.
Check the terms of the issue, any call dates, and to what, specifically, the stated rate of interest is tied.
There are a number of investments that are inflation sensitive, foremost among them are commodities like oil and gas and precious metals, which tend to rise when the overall cost of goods and services is rising. Purchasing convertible bonds and convertible preferred shares of companies in these sectors offers investors both annual income opportunities and the chance for capital gains.
Because convertible securities are exchangeable into the company's underlying common shares, they will tend to mirror the performance of the common. So long as the companies themselves are solvent, and the dividend or interest payment secure, convertible securities offer a tremendous play on inflation and rising rates. (For more on convertible securities, see our Introduction to Convertible Bonds article and Introduction To Convertible Preferred Shares.)
Risks of Convertibles:
Credit risk is the chief worry here. As per usual, check the raters (Moody's, S&P, Fitch, etc.) to better understand what's at stake.
Note the terms of the issue. These securities are packaged in a myriad of ways. Your broker or advisor should help you get a copy of – and understand all the details of – the issue's prospectus.
5. Consider Junk
The spread between high-yielding (junk) bonds and higher rated issuers (like Treasuries) tends to close as inflation heats up. This may make for a positive experience for junk bond holders who, if they've chosen their issues conservatively, will gain from the interest rate premium inherent in junk bonds, and from any capital appreciation in prices as spreads tighten.
High yield bonds are strange animals insofar as they have all the features of debt obligations but trade like stocks. That is, the price of ABC company's junk bond is heavily correlated with ABC company's stock and trade more or less independently of prevailing interest rates. (See our article High Yield, Or Just High Risk? to learn more about junk bonds.)
Risks of Junk Bonds:
More than any of the foregoing, proper junk bond selection is the key to profiting from this asset class. A thorough examination of the creditworthiness of the issuer is imperative. Either that, or leave it to the experts. A number of high yield ETFs and mutual funds are available that offer professional management and both monthly and quarterly income options.
Depending upon your risk tolerance and your desire for capital gains, it is possible to venture beyond traditional, government issued, inflation protected bonds when the yield curve is on the rise. The above listed strategies and products give investors an idea of just a few of the wide range of income investment alternatives available to them under such circumstances. Prudently assessing individual risk/reward profiles for each investment is, of course, crucial to benefiting from any of them. (For a related reading, check out Common Mistakes By Fixed-Income Investors.)