Morningstar Advisor - August/September 2010 - 54

In Practice

How to Make Your Bond Portfolio Inflation-Resistant
By Marta Norton

When prices rise, fixed-income investors have the means to withstand the threat.

With stagnant home prices and unemployment near 10%, U.S. deflation has been harder to shake than many would have guessed. Yet, rock-bottom rates and massive stimulus give many investors, including us, reason to believe that inflation could pick up at some point down the road. If and when we see signs that seem to augur rising prices—for example, stabilizing rents, rising average wages, higher capacity utilization—we will tactically adjust the portfolios that we manage in the name of managing total return and risk. We might shorten duration or overweight hard assets, to name a few possibilities. But those adjustments aren’t necessarily options for investors who depend on a fixed income, such as retiring baby boomers who will likely require more exposure to bonds in the years to come. So, how does one create a bond portfolio that may mitigate the pressure of rapidly rising prices without taking on lots of risk? Drawing on our experience managing income-oriented portfolios for clients, we’ve prepared the following summary of useful vehicles that investors can incorporate into their fixed-income portfolios in an effort to combat inflation. To facilitate portfolio construction and illustrate how these various

securities could be applied in practice, we’ve also drawn-up a hypothetical “inflation-fighter” bond portfolio.
TIPS, the Obvious Choice

the threat of rising real rates. It’s likely that TIPS will remain a staple for the inflationminded, but at a lower allocation than their historical performance—earned at higher real yields—would dictate.
Bank Loans Bridge the Gap

Treasury Inflation-Protected Securities are the obvious inflation hedge. The federal government adjusts the bonds’ principal twice a year to account for changes in the Consumer Price Index. In effect, an investor who holds TIPS to maturity locks in a real yield while gaining complete inflation protection. No other bond can match that. It’s the intermediate term that gives us pause. Should real interest rates—that is, interest rates adjusted for inflation—move higher, TIPS will suffer. That’s an important consideration now, with real yields on 10-year TIPS sitting at around 1.5%, a far cry from the 3.5% to 4% real yields of the 1990s. That, in a nutshell, is why inflation protection is not simply a matter of loading up on TIPS. True, investors who hold to maturity need only concern themselves with the opportunity cost of collecting a lower real yield than the prevailing rate during the bond’s term. But that’s cold comfort to fixed-income investors who are unnerved by fluctuations in the value of their holdings in the interim. We think that investors need to carefully consider TIPS’ ability to hedge inflation against

We mentioned earlier our impulse to shorten portfolio duration in anticipation of rising inflation. In doing so, we reinvest maturing principal sooner at higher rates, blunting the impact of rates propelled higher by rising prices. Yet, as any incomeoriented investor can attest, shortening one’s portfolio can exact its own form of punishment, especially at times like now, when the yield curve is very steep. Bank loans can help to bridge the gap. As short-duration bonds, investors can use bank loans to shorten their portfolio’s duration without giving up as much yield. Because bank loans typically set their coupon payments as a spread over the threemonth London Interbank Offered Rate and adjust them quarterly, their coupons float higher as interest rates rise. It’s worth noting that generally lower-rated companies issue bank loans, so credit risk is a factor that inflation-minded investors should consider. True, bank loans are a form of senior debt accorded higher priority in

54 Morningstar Advisor August/September 2010

Morningstar Advisor - August/September 2010

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