Today we’re going to talk about one of the biggest challenges for investors: How can you invest successfully in fixed income when you’re confronted by its Public Enemy Number One—high inflation?
Let’s start by recalling the two rationales for having a portion of your wealth invested in fixed income.
First, suppose you want to generate cash for current living expenses. Fixed income instruments such as bonds and preferred stocks provide higher yields than a stock portfolio designed with a primary emphasis on increasing your wealth.
That brings us to the second reason for allocating a portion of your assets to fixed income. The equity market has proven itself as a long-run wealth-builder, but stocks are subject to wide price swings from year to year. Bonds are generally less volatile than stocks, so combining them in a portfolio with stocks produces steadier performance over time.
If inflation starts to accelerate, however, it exposes a vulnerability of fixed income. Suppose you buy ten bonds of an issue with a 5 percent coupon at face value. That’s a total investment of $10,000 to generate an annual income of $500. The problem is that inflation reduces the purchasing power of that $500. Each year, the amount of goods and services you can buy for that amount declines.
And that’s not the only problem. Although bond prices are more stable than stock prices, it doesn’t mean they can’t go down. One of the most important facts to know about bonds is that when interest rates go up, bond prices go down.
Another relationship to keep in mind is that when inflation goes up, interest rates go up. During the period 1962-2023, when the year-over-year rise in the Consumer Price Index (CPI) was less than 4 percent, the benchmark ten-year Treasury yield averaged 4.92 percent. When CPI was 4 percent or greater, the ten-year Treasury yield averaged 7.71 percent. So if you see inflation heading higher, you can figure on interest rates going up and bond prices going down.
This is why inflation has earned that title of fixed income’s Public Enemy Number One. Not only does it lower the purchasing power of the income, but it also reduces your wealth by pushing down the value of your bond portfolio. Preferred stocks with fixed dividend rates are similarly vulnerable.
The good news for you as a fixed income investor is that you’re not powerless when the inflation rate starts to rise. Several strategies are available to combat erosion of purchasing power and loss of asset value. They typically involve some near-term sacrifice in income, but benefit you over a more extended period.
Inflation-Indexed Treasury Bonds
Strategy #1 is to own Treasury Inflation-Protected Securities, also known as TIPS. They’re different from ordinary Treasury bonds or corporate bonds, for which the face value begins at $1,000 on the issue date and stays there all the way until maturity. TIPS adjust their face value according to the Consumer Price Index. The coupon rate stays the same, but if inflation causes the face value to go up, you get paid the stated interest rate on a larger amount. You then have more cash coming in each year.
Furthermore, when the bond reaches maturity, if the face value has increased due to inflation, you don’t just get $1,000 back. You receive the original face value plus the increase in face value that has resulted from the rise in CPI. By the way, if inflation gives way to deflation, and you bought the TIPS bond at the time of issue, there’s a floor under your bond’s value at maturity. It’s never less than the $1,000 face value the bond had when it was originally issued.
The U.S. Treasury also offers Series I Savings Bonds. They’re indexed to inflation, but unlike TIPS, they don’t pay you cash interest every six months. You receive the interest on TIPS when they mature, 30 years after issuance, or when you redeem them. You can redeem TIPS after 12 months, but you’ll incur a penalty of three months’ worth of interest. There’s no penalty if you redeem after five years. Note that I Bonds are not tradable in the secondary market and you can buy only a maximum of $10,000 worth in any calendar year.
Managing the Inflation-Interest Rate Connection
As detailed above, heading into a higher-inflation environment very likely means you’re also heading into a higher-interest-rate period. Lenders want to earn a positive real return. That is, they demand an interest rate that more than makes up for the steady loss of purchasing power occasioned by the rising CPI. You need to make sure you’re not left behind in investments carrying the lower yields that prevailed before inflation began its ascent.
One way to avoid that predicament is to move into shorter-maturity bonds when signs of a pickup in inflation appear. You’ll get your principal back comparatively soon, enabling you to reinvest it at the higher rates brought about by heightened inflation. This strategy may entail a near-term sacrifice of income because in most periods, short-term interest rates are lower than long-term interest rates. On the favorable side, shorter-term bonds are generally subject to smaller price swings than longer-term bonds.
A different approach may be appropriate if you aren’t relying on your fixed income investments to meet current expenses, but instead holding them in a tax-deferred portfolio such as an IRA from which you’ll start withdrawing cash many years in the future. In that case, your long-run return will actually increase as a result of the rise in interest rates. That’s because you’ll be able to reinvest your coupons at the new, higher rates. To maximize that effect, hold on to your longer-maturity, higher-yielding bonds rather than swapping them for shorter-maturity, lower-yielding ones.
“Fixed” Income That Increases as Interest Rates Rise
The term “fixed income” can be misleading in a way that could cause inflation-wary investors to miss some opportunities to improve their position. Not all debt instruments have payments that are fixed in the sense that they can never vary. The sense in which all bond coupons are fixed is that they are contractual obligations. That’s in contrast to common stock dividends, which may be reduced or omitted at the discretion of the company’s board of directors.
Floating rate securities are available from The U.S. Treasury, government-sponsored enterprises, and corporations. You can also invest in these instruments through mutual funds devoted to them.
The interest rate on a “floater” is periodically reset as its designated benchmark rate rises or falls. Examples of benchmarks used to determine the reset include the year-over-year change in CPI, Treasury bill rates, and other market-driven rates.
Adjustable-rate preferreds provide similar advantages in a rising-rate environment. In addition, numerous mutual fund organizations offer funds made up of bank loans. Interest payments on the underlying loans increase as their benchmark rates rise.
Include a Growth Component in Your Income Portfolio
As noted above, common stock dividends can be reduced or omitted at the discretion of the board of directors. Why, then, might you consider including dividend-paying stocks in a portfolio intended to produce stable income? The answer is that stable (or to state it differently, static) income is not the optimal objective. A better target is a steady or rising real income, that is, income as measured in purchasing power, which is reduced by inflation. Real income is what really pays the bills, not nominal income—what you earn in non-inflation-adjusted dollars. Owning a portfolio consisting solely of bonds with fixed-rate coupons will not achieve a steady real income as long as CPI is rising by more than 0.0% a year.
Yes, boards of directors can cut dividends but they can also raise them. Within the universe of stock issuers are numerous companies that have regularly increased their payouts over periods of many years. They’ve demonstrated that they desire to attract long-term shareholders who will remain invested in their stocks in the expectation that their income will continue to rise.
Doing likewise can help you counter the erosion of real income on fixed-rate bonds and preferred stocks. The key is to identify companies that not only have long-running records of boosting their dividends, but also have strong enough earnings prospects to enable them to continue doing so. Another important criterion is a dividend payout ratio (dividend as a percentage of earnings) far enough below 100 percent to enable the company to continue raising its dividend even if its earnings growth slows down somewhat.
In addition to common stocks, closed-end funds and real estate investment trusts (REITs) also have the capability of raising their distributions to investors. As with stocks, it’s important to look for a longstanding record of increases. Also, you need to make sure that there’s continuity between the present management team and the team that generated rising payouts in the past.
Conclusion
Inflation is a nemesis for investors who depend on income generated by the wealth they’ve accumulated But you don’t have to take it lying down if the inflation rate starts going up. A variety of strategies and vehicles are available to help you fight back. The right mix of them depends on your particular financial circumstances and your ability to take risk. But regardless of your investment profile, it’s worth your while to educate yourself about the various choices described in this article.
