Fixed income investments are vital in a well-diversified portfolio because they provide downside protection and portfolio ballast in uncertain times. However, some investors are concerned about the impact of growing consumer prices on their bond holdings in this year’s scenario. The Fed has maintained that the current inflationary pressure is only temporary. Many of your clients, however, may be looking for fixed income investment methods to protect their portfolios against inflation risk.
Although it is impossible to totally avoid the effects of rising inflation on fixed income, the risk can be reduced. Let’s take a look at four ways to assist you manage risk in a fixed-income portfolio.
Shorten Duration
The possibility for interest rates to rise is the key issue for fixed income investors as inflation rises. Rising interest rates put downward pressure on fixed income investments, causing bond prices to fall. Interest rate risk is the term for this.
The sensitivity of a fixed income investment to a given change in interest rates is measured by its duration, with higher-duration assets often experiencing more price volatility in response to a rate change. If interest rates rise by 1%, the price of a bond with a 5-year tenure, for example, is predicted to decline by 5%. In comparison, with the same change in interest rates, a bond with a tenure of 2 should experience a 2% decrease in price.
Shortening the tenure of a portfolio to battle rising rates is one of the first fixed income investment strategies you might explore. The goal of this technique is to reduce the portfolio’s interest rate risk. Given the current low interest rate environment, however, simply shortening length may not be enough to ensure that a portfolio is appropriately safeguarded while also generating an acceptable return.
Increase Spread Risk
Orienting allocations away from interest rate-sensitive items and toward spread-based products is another popular method for reducing risk in a fixed income portfolio. Corporate bonds, mortgages, and high-yield investments are examples of spread-based investments.
These investments are riskier than investments that have historically been interest rate sensitive, such as long U.S. Treasury bonds, but the risk is primarily focused on credit risk. Improved economic fundamentals often support corporate bonds, mortgages, and high-yield investments. As a result, increasing rate conditions with greater economic development can benefit them. Spread-oriented assets may make sense for your clients’ portfolios, given the drivers of recent inflation, such as reopening attempts and economic recovery.
It’s vital to remember that corporate bonds, mortgages, and high-yield investments are all susceptible to rising interest rates’ negative impact on prices. Nonetheless, shifting from largely interest rate-sensitive to spread-oriented investments might help a fixed income allocation’s interest rate risk. By shifting risk exposure to credit, these investments can provide a reasonable return.
Add Foreign Exposure
You can also suggest that a portion of your clients’ fixed income allocation be shifted to overseas exposure. Global interest rates are influenced by a variety of factors, but the economic fundamentals of particular countries are the key drivers of national rates. Tactical possibilities in developed and emerging international markets may occur as a result of the diverging global economic recovery.
A portfolio with overseas exposure is less susceptible to interest rate risk in the United States. As a result, in a rising rate environment, it may help to reduce price volatility for your fixed income exposure. As of this writing, international bond valuations are reasonably attractive when compared to domestic counterparts.
This strategy, like spread-oriented assets, exposes you to interest rate risk. Diversifying exposure to include foreign interest rate risk, however, may help reduce overall portfolio volatility.
Employ Yield Curve Positioning
Focusing on important rate length is another method to examine. Holding a diverse portfolio of fixed income investments distributed over the yield curve can help you reach this goal. When it comes to interest rate risk, most hypothetical scenarios foresee rates moving in lockstep across the yield curve.
These cases, in theory, allow for reasonably straightforward duration computations. In practice, however, this is rarely the case, as interest rates are influenced by a variety of factors depending on where a portfolio is located on the yield curve. Short-term interest rates are highly influenced by the Federal Reserve’s present monetary policy, but longer-term interest rates are more influenced by the prospect for long-term economic growth. Given the many variables that influence interest rates, a diversified approach across a fixed income allocation can assist guard against nonparallel interest rate swings.
A portfolio comprised primarily of 5-year Treasury notes, for example, may experience higher volatility than a portfolio comprised of 1- and 10-year Treasury instruments. Even if the portfolios have the same average duration, this scenario would usually hold. If intermediate-term rates rise but long- and short-term rates remain steady, a portfolio consisting solely of 5-year Treasury notes is likely to experience more price volatility than a diversified portfolio. Holding a diverse portfolio of fixed income assets across the yield curve may reduce the portfolio’s sensitivity to fluctuations in yield in certain market segments.
The Benefits of Diversification
The purpose of a fixed income allocation, in the end, is to supplement other portfolio holdings that are projected to do well in an inflationary climate. While admitting the risks of inflation, discuss with clients the diversification benefits and potential for downside protection that fixed income can give to a portfolio. In the current inflationary climate, employing one or more of the fixed income investment methods discussed above could assist limit risks.
This information is provided solely for educational and informational reasons and should not be construed as investment advice, a solicitation, or a recommendation to purchase or sell any securities or investment product.
Bonds are subject to supply and demand, and some include call features that can reduce income. Bond prices and yields are inversely related: as the price rises, so does the yield, and vice versa. If sold or redeemed before maturity, market risk is a factor to consider.
Diversification does not ensure a profit or safeguard against loss in deteriorating markets, and it does not guarantee the achievement of any target or goal. Currency fluctuations, differences in accounting techniques, foreign taxation, economic, political, or financial instability, a lack of timely or reliable information, or negative political or legal developments are the main hazards of international investing.
How can a company reduce the danger of inflation?
To counteract inflation risk, investors have two options: portfolio modifications and spending adjustments. Common inflation hedges, such as Treasury Inflation-Protected Securities (TIPS), commodities, and reduced bond exposure, are included in portfolio modifications. The focus of spending adjustments is on rule-based techniques to keep spending under control.
While portfolio modifications receive more attention, spending changes are more likely to be predictable and have a greater influence over time. They also have the benefit of being able to work in a variety of market scenarios, not simply those that we can foresee ahead of time.
What is the risk of inflation?
Inflation risk, also known as purchasing power risk, is the possibility that inflation would reduce the real value of an investment’s cash flows.
Fixed-income assets plainly show the danger of inflation. If you buy a bond with a coupon rate of 3%, the nominal return on your investment will be this. However, if the inflation rate is 2%, your purchasing power will only increase by 1%.
What investments do well in the face of inflation?
- In the past, tangible assets such as real estate and commodities were seen to be inflation hedges.
- Certain sector stocks, inflation-indexed bonds, and securitized debt are examples of specialty securities that can keep a portfolio’s buying power.
- Direct and indirect investments in inflation-sensitive investments are available in a variety of ways.
How can I plan for inflation in 2022?
With the consumer price index rising at a rate not seen in over 40 years in 2021, the investing challenge for 2022 is generating meaningful profits in the face of very high inflation. Real estate, commodities, and consumer cyclical equities are all traditional inflation-resistant assets. Others, like as tourism, semiconductors, and infrastructure-related investments, may do well during this inflationary cycle as a result of the pandemic’s special circumstances. Cash, bonds, and growth stocks, on the other hand, look to be less appealing in today’s market.
Do you want to learn more about diversifying your investing portfolio? Contact a financial advisor right away.
Who is the hardest hit by inflation?
Inflation is defined as a steady increase in the price level. Inflation means that money loses its purchasing power and can buy fewer products than before.
- Inflation will assist people with huge debts, making it simpler to repay their debts as prices rise.
Losers from inflation
Savers. Historically, savers have lost money due to inflation. When prices rise, money loses its worth, and savings lose their true value. People who had saved their entire lives, for example, could have the value of their savings wiped out during periods of hyperinflation since their savings became effectively useless at higher prices.
Inflation and Savings
This graph depicts a US Dollar’s purchasing power. The worth of a dollar decreases during periods of increased inflation, such as 1945-46 and the mid-1970s. Between 1940 and 1982, the value of one dollar plummeted by 85 percent, from 700 to 100.
- If a saver can earn an interest rate higher than the rate of inflation, they will be protected against inflation. If, for example, inflation is 5% and banks offer a 7% interest rate, those who save in a bank will nevertheless see a real increase in the value of their funds.
If we have both high inflation and low interest rates, savers are far more likely to lose money. In the aftermath of the 2008 credit crisis, for example, inflation soared to 5% (owing to cost-push reasons), while interest rates were slashed to 0.5 percent. As a result, savers lost money at this time.
Workers with fixed-wage contracts are another group that could be harmed by inflation. Assume that workers’ wages are frozen and that inflation is 5%. It means their salaries will buy 5% less at the end of the year than they did at the beginning.
CPI inflation was higher than nominal wage increases from 2008 to 2014, resulting in a real wage drop.
Despite the fact that inflation was modest (by UK historical norms), many workers saw their real pay decline.
- Workers in non-unionized jobs may be particularly harmed by inflation since they have less negotiating leverage to seek higher nominal salaries to keep up with growing inflation.
- Those who are close to poverty will be harmed the most during this era of negative real wages. Higher-income people will be able to absorb a drop in real wages. Even a small increase in pricing might make purchasing products and services more challenging. Food banks were used more frequently in the UK from 2009 to 2017.
- Inflation in the UK was over 20% in the 1970s, yet salaries climbed to keep up with growing inflation, thus workers continued to see real wage increases. In fact, in the 1970s, growing salaries were a source of inflation.
Inflationary pressures may prompt the government or central bank to raise interest rates. A higher borrowing rate will result as a result of this. As a result, homeowners with variable mortgage rates may notice considerable increases in their monthly payments.
The UK underwent an economic boom in the late 1980s, with high growth but close to 10% inflation; as a result of the overheating economy, the government hiked interest rates. This resulted in a sharp increase in mortgage rates, which was generally unanticipated. Many homeowners were unable to afford higher mortgage payments and thus defaulted on their obligations.
Indirectly, rising inflation in the 1980s increased mortgage payments, causing many people to lose their homes.
- Higher inflation, on the other hand, does not always imply higher interest rates. There was cost-push inflation following the 2008 recession, but the Bank of England did not raise interest rates (they felt inflation would be temporary). As a result, mortgage holders witnessed lower variable rates and lower mortgage payments as a percentage of income.
Inflation that is both high and fluctuating generates anxiety for consumers, banks, and businesses. There is a reluctance to invest, which could result in poorer economic growth and fewer job opportunities. As a result, increased inflation is linked to a decline in economic prospects over time.
If UK inflation is higher than that of our competitors, UK goods would become less competitive, and exporters will see a drop in demand and find it difficult to sell their products.
Winners from inflation
Inflationary pressures might make it easier to repay outstanding debt. Businesses will be able to raise consumer prices and utilize the additional cash to pay off debts.
- However, if a bank borrowed money from a bank at a variable mortgage rate. If inflation rises and the bank raises interest rates, the cost of debt repayments will climb.
Inflation can make it easier for the government to pay off its debt in real terms (public debt as a percent of GDP)
This is especially true if inflation exceeds expectations. Because markets predicted low inflation in the 1960s, the government was able to sell government bonds at cheap interest rates. Inflation was higher than projected in the 1970s and higher than the yield on a government bond. As a result, bondholders experienced a decrease in the real value of their bonds, while the government saw a reduction in the real value of its debt.
In the 1970s, unexpected inflation (due to an oil price shock) aided in the reduction of government debt burdens in a number of countries, including the United States.
The nominal value of government debt increased between 1945 and 1991, although inflation and economic growth caused the national debt to shrink as a percentage of GDP.
Those with savings may notice a quick drop in the real worth of their savings during a period of hyperinflation. Those who own actual assets, on the other hand, are usually safe. Land, factories, and machines, for example, will keep their value.
During instances of hyperinflation, demand for assets such as gold and silver often increases. Because gold cannot be printed, it cannot be subjected to the same inflationary forces as paper money.
However, it is important to remember that purchasing gold during a period of inflation does not ensure an increase in real value. This is due to the fact that the price of gold is susceptible to speculative pressures. The price of gold, for example, peaked in 1980 and then plummeted.
Holding gold, on the other hand, is a method to secure genuine wealth in a way that money cannot.
Bank profit margins tend to expand during periods of negative real interest rates. Lending rates are greater than saving rates, with base rates near zero and very low savings rates.
Anecdotal evidence
Germany’s inflation rate reached astronomical levels between 1922 and 1924, making it a good illustration of high inflation.
Middle-class workers who had put a lifetime’s earnings into their pension fund discovered that it was useless in 1924. One middle-class clerk cashed his retirement fund and used money to buy a cup of coffee after working for 40 years.
Fear, uncertainty, and bewilderment arose as a result of the hyperinflation. People reacted by attempting to purchase anything physical such as buttons or cloth that might carry more worth than money.
However, not everyone was affected in the same way. Farmers fared handsomely as food prices continued to increase. Due to inflation, which reduced the real worth of debt, businesses that had borrowed huge sums realized that their debts had practically vanished. These companies could take over companies that had gone out of business due to inflationary costs.
Inflation this high can cause enormous resentment since it appears to be an unfair means to allocate wealth from savers to borrowers.
Is gold a good inflation hedge?
Gold is a proven long-term inflation hedge, but its short-term performance is less impressive. Despite this, our research demonstrates that gold can be an important part of an inflation-hedging portfolio.
Are bonds beneficial during periods of inflation?
Bonds’ deadliest enemy is inflation. The purchasing power of a bond’s future cash flows is eroded by inflation. Bonds are typically fixed-rate investments. Inflation (or rising prices) reduces the return on a bond in real terms, which means adjusted for inflation.