Bonds are not usually the first asset class experienced investors focus on when it comes to inflation. But even during times of rising price levels, there’s a need to make sure that at least some of your portfolio is held in relatively safe assets. Bonds qualify as safe assets because they pay a fixed rate of interest, and payment of principal is generally guaranteed if the securities are held until maturity.
How exactly do bonds fit into your portfolio when dealing with inflation?
Fortunately, there’s an entire class of bonds that are designed specifically to provide protection against inflation. Holding at least some of these bonds in your portfolio can both protect your holdings from inflation while providing a higher level of security that you can get with a portfolio comprised entirely of equities, or even other bonds.
What makes bonds a risky bet during times of inflation is rising interest rates. Those rates are at least loosely correlated to inflation. As the rate of inflation increases, investors naturally demand a higher return on bonds to compensate for higher price levels.
But since bond price levels have an inverse relationship with interest rates, rising inflation – and the higher interest rates it causes – can make bond prices fall.
For example, let’s say you’re holding a 20-year bond currently paying 3%. If inflation causes prevailing interest rates on 20-year securities to rise to 4%, the market value of your bond will decline until the interest yield is more consistent with prevailing rates. (You’ll still receive the full principal value of your bond upon maturity, but you could suffer a capital loss if you sell it in the rising rate environment.)
Interest rate risk is greater on longer-term bonds, particularly those with maturities of 20 years or more. Bonds with remaining maturities of one or two years may see little if any decline in principal value.
This inverse relationship makes bonds a losing asset class in the face of rising inflation. But as I said earlier, there is one exception to the rule.
That’s TIPS Bonds.
Treasury Inflation Protected Securities, commonly abbreviated as simply TIPS, are U.S. Treasury securities designed specifically to compensate investors for inflation.
Though the bonds will carry a fixed interest rate, the principal value of the securities will increase with inflation. The opposite is also true – the value will decrease in a deflationary environment. However, the securities will pay full face value if they are held to maturity, even in a deflationary market. You’re guaranteed to receive the greater of the adjusted principal value or the original value of the security.
TIPS are issued by the Treasury in denominations $100. Terms come in three tiers, five, 10 and 30 years. Interest on the securities is paid every six months.
While the interest and principal increases are subject to federal income tax, both are exempt from state and local income tax. This gives them at least a slight tax benefit, especially in high tax states.
And since TIPS are issued by the United States Treasury Department, they have the highest safety rating possible.
The secret sauce that protects TIPS from inflation is the principal adjustments added to the security value in response to inflation. The adjustments are based on the TIPS Inflation Index Ratios, which is based on the Consumer Price Index, provided by the Bureau of Labor Statistics.
However, you should be aware that since TIPS offer inflation protection through principal adjustments, the interest rates they carry are lower than U.S. Treasury securities with similar terms.
For example, while the 10-year Treasury note currently pays 1.31%, the yield on the 10-year TIPS note issued on July 15, 2021, is just 0.125%. But the 10-year TIPS note already has an index ratio 1.02062 as of October 31, 2021. That means a little over 2% will be added to the principal value of the security just a little over three months after it was issued.
In that way, the principal added – plus the interest, low that it is – provides a higher combined return than what you can get on the non-TIPS 10-year Treasury note.
If inflation continues to rise, the principal adjustment on the TIPS security will also increase. That’s why TIPS are the exception to the general bond rule when it comes to inflation. They provide guaranteed principal, protected from inflation, with a steady income stream, and even exemption from state and local income tax.
You can invest in TIPS directly through the U.S. Treasury’s investment portal, Treasury Direct. There, you can buy, hold, and even sell your securities.
But if you’d rather invest in a portfolio of TIPS securities, there are many bond funds that specialize in this asset class. They can provide a mix of interest rates and maturity dates, and even enable you to target specific maturity ranges, like five years or less, or 10 years or more.
What’s more, while TIPS themselves pay interest only twice each year, a TIPS fund may be set up to pay interest on a monthly basis.
Here is the list of what we believe to be the best bond funds for inflation in 2021:
We are putting the Schwab US TIPS ETF (SCHP) at the top of the list because it’s one of the most common TIPS ETFs used by robo-advisors. That speaks volume about the reliability and performance of the fund. It’s also the largest single TIPS ETF on this list, with nearly $20 billion in assets under management.
The fund’s goal is to closely track the performance of the Bloomberg US Treasury Inflation-Linked Bond Index (Series-L), which invests in the overall maturity spectrum of the entire U.S. TIPS market. It’s worth noting this fund has one of the lowest expense ratios in the industry, at just 0.05%.
SPDR FTSE International Government Inflation-Protected Bond ETF (WIP) is an excellent choice if you’re looking for a TIPS equivalent with international diversification. Offered by State Street Global Advisors, the SPDR FTSE International Government Inflation-Protected Bond ETF seeks to provide investment results that match the price and yield performance of FTSE International Inflation-Linked Securities Select Index. That index is designed to measure the total return performance of inflation-linked bonds outside the United States, but similar in that they offer fixed-rate coupon payments that are linked to an inflation index.
The fund includes TIPS equivalents issued by the governments of developed and emerging nations. The main purpose is to hedge against the erosion of purchasing power due to inflation outside of the U.S.
The fund includes government debt TIPS equivalents from Canada, Mexico, Australia, Turkey, South Africa, Brazil, Japan, Israel, Columbia South Africa, Chile and multiple European countries, and is rebalanced on the last business day of each month.
Unlike US-based TIPS funds, in which all bonds held are rated AAA, only 20.32% of the bonds in this fund are rated AAA. Though most of the rest are considered investment grade, more than 30% are either rated below BAA (21.62%) or not rated at all (9.09%).
Given that it is an international bond fund, the yield is heavily impacted by both a high expense ratio (0.50%) and foreign taxes imposed on distributions. It’s also a relatively small fund, with just 8 million shares outstanding.
The FlexShares iBoxx 5-Year Target Duration TIPS Index Fund (TDTF) targets a specific niche in the TIPS bond market. That target is TIPS with maturities approximating five years. However, the fund will hold TIPS with maturities ranging from as little as three years to as many as 20. But the average will be maintained at approximately 5 years. It’s rebalanced on a monthly basis.
Issued by State Street Global Advisors, SPDR® Portfolio TIPS ETF (SPIP) is a popular fund for investors looking to get the benefit of the broad TIPS market. That includes bonds with short-, intermediate- and long-term maturities. The fund has one of the higher annual dividend yields, at 4.20%.
The SPDR Bloomberg Barclays 1-10 Year TIPS ETF (TIPX) seeks to provide exposure to TIPS with remaining maturities between 1 and 10 years. The fund rebalances at the end of each month.
One of the better established TIPS funds, having been launched back in 1997, PIMCO Broad US TIPS ETF (TIPZ) targets the intermediate TIPS market, and has an effective maturity of 9.01 years. Dividends – which are the highest of any fund on this list at 7.90% – are distributed on a monthly basis.
The iShares 0-5 Year TIPS Bond ETF (STIP) seeks to track the investment results of an index composed of inflation-protected U.S. Treasury bonds with remaining maturities of less than five years. The effective duration of securities held by the fund is 2.68 years. It’s also one of the larger funds on this list, with more than $6.6 billion in assets under management. The fund has turned a very respectable one-year performance of nearly 6%.
If you’re not sure which bond fund to invest in, consider Betterment Income Portfolio from BlackRock. It’s designed to provide investors with an opportunity to generate income while also preserving capital. You can use it in conjunction with one or more of the above bond funds, or as a standalone bond allocation for your portfolio. The income/capital preservation mix makes it especially well-suited to retirees.
The Income Portfolio provides a 100% diversified basket of bonds with an opportunity to choose from four different risk levels within a balanced Betterment asset mix, based on your own risk tolerance and preference.
The asset mix within the four risk levels are as follows:
Because any of the four allocations generate substantial income in the form of both interest on bonds and dividends on equity holdings, Betterment generally recommends the Income Portfolio be held in a tax-sheltered retirement account. This is because bond interest is generally taxed at a higher rate than capital gains and dividends.
Betterment advises that the ETFs used for the Income Portfolio carry higher expense ratios than those of their usual mix of investments. While the expense ratios on the ETFs used in their regular portfolios ranges between 0.07% and 0.16%, ratios range between 0.21% and 0.38% within the Income Portfolio.
The ETFs used in the Income Portfolio are selected from BlackRock’s iShares funds. They’re invested in a mix of US and international bonds, including U.S. Treasuries, mortgage-backed securities, corporate bonds, high-yield bonds, and emerging market bonds. The exact allocation of bond types in any portfolio is subject to change given that it’s an actively managed portfolio. It can be adjusted up to six times per year, and generally at least once each quarter.
The reason for using different bond types is to adjust the yield based on the assigned risk level of the portfolio selected. For example, a higher risk portfolio expected to produce higher returns will be invested more heavily in longer-term bonds and lower-quality bonds (like high-yield bonds). One with less risk will be comprised largely of U.S. Treasuries and corporate bonds.
Unlike the funds listed above, the Income Portfolio does not invest primarily in TIPS bonds. But it provides a high rate of return based on the mix of bonds included in the portfolio, though it’s important to understand that the return provided is not specifically correlated to the rate of inflation, the way TIPS are.
Are TIPS the perfect solution to inflation? Probably not, at least not entirely. They can form a solid base for the bond portion of your portfolio, protecting it from the ravages of inflation. But you still need to diversify your portfolio to include other asset classes that will benefit more directly from rising prices.
After all, TIPS are mostly designed to keep your investments even with inflation. But they’re not designed to help you outrun it. For that, you’ll need to look at other assets. But when those are combined with TIPS, it’s likely you’ll have a better chance of conquering inflation in your portfolio than you will by investing in any single asset class.