Inflation Beating Fixed Income Instruments

These asset classes are ways to position for anticipated macro regime shifts.

Kate Lin, CAIA 26.05.2021
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Investors today are worried about inflation, mainly how to comprehend the risk and impact it could have on their portfolios.

U.S. consumer price data is seen speeding up to rise 4.2% over the past 12 months through April, a level last seen almost 13 years ago, just before the Global Financial Crisis. Though some investors are worried about the possibilities of rising prices, U.S. Federal Reserve chair Jerome Powell sounds less perturbed as he describes the inflationary pressure as ‘transitory.’

In the face of mixed signals, investors should continue to be on the watch for macro indicators, like the aggressive stimulus package that has totaled US$ 2.2 trillion with a possibility of more on the way. This may eventually lead to higher inflation. Amy C. Arnott, a portfolio strategist for Morningstar, notes: “the Federal Reserve has been aggressively purchasing bonds and reducing interest rates. The government printing more money is basically a textbook cause of higher inflation because it decreases currency values.”

Arnott says a prudent approach would be to “carve out a portion of your portfolio to guard against different scenarios.” How? The first thing that comes to mind is to identify some direct targets of stocks or bonds that enjoy a boost when prices go up. It isn’t easy or cost-efficient to consider individual assets. Exchange-traded funds are among the low-cost solutions used widely by individual investors, especially first-time investors.

If you want solutions to buffer your portfolio from inflation risks, you could start your research here. We present two groups of ETFs (with Morningstar Analyst Rating or a Morningstar Quantitative Rating of Silver or better available in local or U.S. markets(, mainly with a bond-like return profile, that could bring you through the potential inflation upcycle.

 

Link with Inflation

Typically, once the inflation runs beyond the preset target, say set by the Fed, adjusting the interest rate becomes necessary to curb prices to rise exceedingly. Prices of fixed-income instruments would then become less competitive because higher-yielding alternatives are available. Thus, when inflationary pressure increases, ETFs that are intentionally correlated to the price hike become an option.

Treasury Inflation-Protected Securities (TIPS) is another straightforward way to guard against a potential increase in inflation in two ways. First, their principal value is tied to changes in inflation. Second, their coupon payments are also adjusted based on changes in the principal value. That implies that the total value of TIPS is adjusted to retain its real value. TIPS is backed by the US government, which will pay back at maturity either the adjusted par value or the original principal, whichever is higher.

 

Reduce Inflation Sensitivity

The second way to minimize the negative impact of inflation is to get around the inflation-sensitive assets. In bond investing, duration is a metric of how sensitive a bond is to interest rate risk. It is the weighted average of the time periods until a bond or bond portfolio's interest and principal payments are received, expressed in years. When interest rates change, the price of a bond will change by a corresponding amount related to its duration.

Morningstar senior fund analyst Matthew Wilkinson says: “The nuance here is the longer your maturity, the more affected you are by the change in interest rate.” He takes the average of the global aggerate bond index as an example, which on average has a maturity of seven years. “For example, if you have a maturity of seven years, you're more affected by interest rate rises than if you're in a product that has a maturity of less than seven.”

Adding short-duration bonds into a portfolio with ETF proves to reduce the overall sensitivity of interest rate changes at a low cost.

 

In Part II, we look into two broad equity sectors that tend to follow the inflation hike cycle.

 

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About Author

Kate Lin, CAIA

Kate Lin, CAIA  is a Data Journalist for Morningstar Asia, and is based in Hong Kong

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