How Fixed Income Investors Can Navigate Sustained Inflation
Is it time to rebalance your portfolio from stocks to bonds?
For many investors it is – yet most are afraid of what high inflation will do to their portfolio in the future. After all, there are financial horror stories from the 1970’s with riots over “guaranteed” pensions and “risk free” investments (i.e., treasury bonds) getting hammered when interest rates shot up to 16%!
For me, the answer to successfully investing through difficult situations lie in knowing the past. I have a large collection of financial books dating back to the 1800’s, and the danger of inflation looms large in most of them – especially books written by inflation battered investors 45 years ago.
For instance, read what was written in “Fixed Income Securities” by Fabozzi & Pollack (1981), “Everyone knows inflation brings high interest rates…government officials, economist, fixed income managers, stockbrokers, corporate executives, the man on the street… And the higher the inflation, the higher the interest rates.”
It is widely agreed upon inflation is here, so let’s look at some historical facts:
What is inflation? The erosion in the value of the U.S. dollar. This is mainly caused by poor government policies that overproduce the amount of currency publicly held which does not take into account the limited availability of goods and services for consumption.
A textbook example of this is after the U.S. government took the dollar off the gold standard in 1971, the new “fiat-dollar” declined 30% versus other currencies thus exasperating the inflationary 1970’s.
Inflation & high taxes go together: During the last two inflationary periods, investment related taxes were significantly raised. In fact, the last time the capital gains tax rate increased to 40% was 1977 – a double hit for many investors that retarded U.S. asset appreciation for many years.
Are we in a high inflation period? Since the Civil War, the annual US inflation rate has been as high as 25% (in 1864) and has averaged 2.2%. Today, The Consumer Price Index is at 5.2% – a level not seen since the early 1980’s! (See chart)
How long does inflation last? During the last two inflation spikes which occurred at the end of World War Two (1944-52) and during the turbulent 1970’s (1972-80), the cycle went on for nearly eight years.
It’s also important to note that the level of inflation doesn’t historically shoot straight up but rather ebbs & flows to higher levels over many years. This is one of the reasons that investment values can be abnormally volatile during these periods. (See chart)
How do bond investments react during inflation? High agency ratings will not protect bond values as all bond mediums suffer high price volatility during inflation. As the yield charts below show, different types fixed income holdings had large swings at different intervals during inflationary periods. (See charts)
What should fixed-income investors do?
Yes, it’s true that many fixed income investors had devastating losses during the 1970’s and the end of WW2 because interest rates dramatically rose (bond prices dropped) in response to the rising cost of living. Ultimately, these losses stemmed from a poor investment strategy – not the fixed income investments themselves.
I outlined in my book “Preferred Stock – The Art of Profitable Income Investing” (2009) four key items that should allow investors to be successful in this type of economic environment:
1. Focus on maturity – not yield: The greatest advantage a fixed-income investment has over other investments (stocks, real estate, commodities) is the near-certainty of interest payments and return of principal at maturity. During an inflationary spiral, interest rates ultimately climb, and the market price of long-term bonds are volatile. The investor’s focus needs to shift from total return to low volatility & income generation.
This is best done by buying bonds from diverse issuers with various maturities (2 to 10 years) and hold until maturity (a laddered strategy). Since short term bonds are less volatile, higher levels of inflation should be matched by shortening the portfolio’s average maturity. Since individual bonds regularly mature, funds can be invested in new bonds at higher yields thus systematically increasing the overall portfolio’s projected returns.
2. Reinvestment of income: To reduce the inflation erosion in the real maturity value of the portfolio, reinvest 10% of the interest in new fixed-income investments (bonds, preferred stocks, etc.).
3. Account placement for tax avoidance: Since the combined effects of high inflation and investment taxes can devastate a portfolio, it is critical place taxable income investments in tax deferred accounts (IRA, SEP, 401-K) where income is only taxed when withdrawn from the account. This allows income to be reinvested on a tax-deferred basis. Also, consider using preferred shares with qualified dividends in taxable accounts since the dividends are taxed at lower capital gains rates. Caution needs to be used when investing in “tax free” municipal bonds since high income earners could be subjected to alternative minimum taxes that impose penalties on muni bond interest.
4. Investment Patience: Since good bonds can be scarce & illiquid, there are times when income investors should temporarily hold cash to look for future buying opportunities that will present themselves – especially in a volatile inflation cycle.
It’s easy to think it’s different today, and to assume we are smarter than our predecessors.
In my periodical collection, there is a 1934 article titled, “No Such Thing as Controlled Inflation” which states, “We must abandon our complacent indifference to debt and revive our fundamental conceptions of money or face the dire consequences of fiat currency.”
As we face unsustainable borrowing of trillions of dollars in outstanding Treasury and Municipal debts (that will never be entirely paid off), I hope today’s politicians and bureaucrats in Washington will pay attention to this timeless advice as unchecked inflation has historically led to worthless money and global economic & military conflicts.