Fixed Income Investments to Mitigate Future Higher Inflation

Because of lower housing prices, high unemployment and stagnant wage increases, the US economy has recently experienced little or no inflation. This has led to excellent performance for most bonds and other fixed income investments. But at some point in the future, rents will stabilize and wages will start to rise. Fixed income investors may want to adjust their portfolios now to add some securities that will perform better when there is higher US inflation.

Here are some choices to consider:

1) Bank Loans: These are short duration bonds that typically reset their quarterly coupon rate based on a spread over the three month LIBOR rate, so the coupon floats higher when inflation andinterest rates increase. Note that many of these bank loans are issued by lower-rated companies. But bank loans are a form of senior debt that have priority in the pecking order when there is a default, so a high repayment rate is likely.

There are many closed-end funds available in this category. Two funds that are reasonably attractive now are VVR and JFR.

2) TIPS: Treasury Inflation-Protected Securities seem like an obvious inflation hedge, since the Federal Government adjusts the bond principal twice a year based on changes to the CPI. But there are few problems with TIPS right now:

  • – the CPI often understates the true rate of inflation
  • – the real interest rate on the 10-year TIPS is now a very low 1.10%. This is much less than the 3.5% real rate that existed twenty years. If real rates rise to those levels again, the price of TIPS bond will drop substantially.

I wouldn’t recommend it now, but the closed-end fund WIW is often available at an attractive discount to NAV and could be worth buying if the 10-year TIP yield goes back over 2%.

3) High Yield funds: If inflation rises to 3 or 4%, high yield bonds can offer more protection than Treasury bonds. The higher inflation would likely be caused by a stronger economy, which would mean a lower default rate on high yield bonds. And inflation would be a smaller percent of the income cash flows for high yield bonds. There are many good open end mutual funds available, and the closed-end fund BHY is available at a discount to NAV.

4) Emerging market bond funds: Given the large growing US federal deficit, there is a risk that the Federal Reserve will increasingly print money to inflate away this debt. This risk is much lower in many emerging market countries where the debt to GDP ratio is much lower than in the US. An investor who fears future US inflation can look to emerging market bonds as a potential refuge. Within the closed-end fund space, there are several attractive funds available including MSD and AWF.

5) Convertible bond funds: Since convertible bonds can be converted into equities, they can provide some inflation protection, since (in theory) earnings should grow higher with inflation, and stock prices are helped by higher earnings. But these funds generally have much higher volatility. There is also a wide variation in credit quality of the underlying companies. That said, there are some attractive discounts available now in some convertible bond closed-end funds including BCV and ECF.

Full disclosure: We own some of the securities mentioned above in client accounts.


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