I’ll bet $1 that several of your friends and family members have put money into bonds over the last year or two. They’re probably saying how much money they haven’t lost instead of how much they’ve made. Bonds and other fixed income products are safe and generate less return as a result, right?
It’s true that high quality bonds are generally safer than stocks. But don’t forget, you can still lose money in fixed income. It says something when the largest fixed income manager, PIMCO led by the famous Bill Gross, announces they are launching a few equity mutual funds for the first time since the late 1980s.
So how can you protect yourself?
Money Pouring Into Bond Funds
According to the Investment Company Institute, since January 2009 over $500 billion has flowed into bond funds, compared to almost zero into equities! People typically move money to bonds when they are scared about the economy, and that’s exactly what is happening. Even people who typically invest in money market funds or CDs are moving to bonds in search of higher yields, since those investments are yielding almost zero. Bond’s perceived safety compared to the alternative is causing demand to skyrocket. Consequently, this is pushing yields lower. I’m sure you’ve seen the declining rates for 15- and 30-year mortgages. (Could be a good time to refinance!)
What Happens When Inflation Arrives?
All the spending and stimulus in the US is creating record deficits that will have to be addressed. A probable outcome will be the Federal Reserve having to increase the amount of money in circulation – an indicator that may lead to inflation.
Part of the economic stimulus has been to lower interest rates to near zero. Lower rates make it cheaper to borrow money and lead to increased consumer spending. Spending leads to growth, which naturally causes some increase in the rate of inflation. If the increased growth is too much the Federal Reserve will have to raise interest rates.
Rising rates make the bonds you own look less and less attractive. The bonds you purchased years ago at low interest rates need to be able to compete with what new bond buyers can get when a higher rate is available. This also lowers the price of your bonds because the market rate is higher. The decline in price of your bond could offset some or all of the interest income generated if sold before maturity.
Interest Income
Say inflation rises to 6% initially. Any fixed income you own yielding 6% or lower will see its real return drop to 0 or less. Why? Because all of a sudden your dollar doesn’t buy as much. Perhaps your fixed income portfolio generates $5000 a month which covers all the basics and the occasional birthday present to a nephew or friend. If inflation rises, the purchasing power of that $5000 decreases and you may need to withdraw $6000 to maintain your lifestyle. How will that affect your long-term retirement plans?
Stock Market
Inflation even affects stock prices and the market. Historically when inflation is at long term average rates 2-3% (which it is close to now), the stock market typically performs well. Even with higher inflation rates like 3-5% you could still see stock prices rise, albeit at a slower rate. Anything more than that and stock prices usually feel some pain. Back in the 1970’s when inflation was at 12%, stocks experienced the longest slump since The Great Depression. Many investors during the 1970’s bought bonds instead of stocks because they were able to get a good interest rate without the headache and risk of owning stocks.
Inflation Will Have to Wait for a Little While Longer
We don’t think inflation will rear its ugly head for awhile. Core inflation has increased 0.9% over the last 12 months, with the ten year average hovering around 2%. Two of the main drivers of inflation are economic growth and low unemployment. US GDP growth is estimated in the 2 - 3% range for 2010 and 2011, as opposed to the 5-7% that we would typically see after a recession. And while we think unemployment is going to come down, it’s not likely to drop below 8-9% anytime soon. Combine that with ongoing issues in Europe and elsewhere, and you have a “Slow but Growing” economy (as suggested in our March 2010 newsletter), resulting in what we feel will be a lower inflation environment
A Few Ways to Protect Your Nest Egg
Rising inflation doesn’t mean you should get rid of all your bond holdings. There are ways to navigate inflation while maintaining your portfolio’s diversification.
Shorter Maturities
A bond with a 5 percent yield may look good today, but what about in seven years when the rate might be 8 percent? Buying short-term or intermediate bonds in a laddered approach with maturities from 1-15 years will allow you to reinvest a portion of the bond proceeds in the future, hopefully at higher interest rates.
Short-term bonds are less sensitive to interest rate swings than longer term bonds. For example, the short-term bond price is estimated to fall 3% if interest rates rise 1%, and vise versa. With a longer term bond, the price is estimated to fall more than 3% if interest rates rise 1%. So the longer the maturity, the higher the interest rate sensitivity, and the higher potential for loss.
Inflation Resistant Securities
You can hire a money manager that buys inflation-resistant investments like commodities and energy. These could be actual commodities like gold, silver, and oil, or companies that deal with them such as mining or energy giants. And while inflation is subdued in the meantime, the potential returns from the stocks may help your portfolio.
Treasury Inflation-Protected Securities (TIPS) can also dampen the effects of inflation. Their interest rate is directly tied to the changes in the Consumer Price Index, as reported by the US Bureau of Labor Statistics. If inflation rises, so does the interest paid by the TIPS.
There are also types of stocks that typically do well in inflationary environments: dividend paying stocks and consumer staples. Investing in stocks with potential for dividend growth allows for the possibility of maintaining or increasing an income stream. Consumer staples such as Proctor & Gamble provide everyday essentials like toilet paper and toothpaste. Because most people will always buy these products, the companies are able to pass on the higher cost of goods to the consumer, which is then reflected in their revenue and earnings per share. But remember that other types of companies may not do as well in comparison.
Which Strategy is the Best for You?
There are several more options than the ones listed above. Your portfolio and financial situation is unique and therefore some strategies may not be suitable. We help our clients identify appropriate fixed income solutions for all types of situations. If you’re worried about protecting your nest egg or want to learn more about fixed income investing, give one of our wealth advocates a call at (800) 541-7774.
We believe having a plan is so important that we highly recommend it to all our current and new clients. It doesn’t take that long and from the feedback we’ve received, most even enjoy going through the process and finding out where they are financially. Call us today or have a Wealth Advocate contact you to get started.
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