BLK BlackRock Inc

If inflation returns, here are six strategies to protect a portfolio

By Michael A. Pollock 

With the global economy so sluggish, can bond investors rest easy about inflation? Not necessarily. Excluding energy prices, inflation might not be as tame as many think it is. Moreover, the Federal Reserve, which stands guard over inflation, has signaled an unusual willingness to tolerate inflation at a faster pace.

That is just what could result if the Fed raises interest rates only gradually while the job market continues to heat up.

The Fed monitors several indexes of inflation, which vary according to what prices are included. The most widely watched by investors, the core consumer-price index, or CPI, rose 2.2% for the 12 months through March. This index excludes food and energy prices. The key index watched by the Fed, however, is the core price index for personal-consumption expenditures, or PCE, which also excludes food and energy. It rose by 1.6% for the 12 months through March.

Few expect that number to surge, in part because of currently depressed energy markets. The Fed itself seems to discount the possibility, as it has signaled it plans to raise rates only gradually. Bond professionals say part of the Fed's hesitation to raise rates also stems from the fact that it doesn't want to cause more of the market volatility seen after it raised rates in December for the first time in nine years.

If, however, the job market continues to heat up, other prices keep rising, and the Fed does tolerate more inflation than in the past, all of that could spell trouble for bondholders.

The apparent policy shift is "a big deal," says Rick Rieder, chief investment officer of global fixed income at money manager BlackRock Inc. A further increase in inflation, he says, could at least temporarily cause yields to rise as bond investors turn elsewhere for higher yields to stay ahead of inflation.

Bond yields move the opposite way as bond prices, so a rise, reflecting an increase in inflation expectations, would cause many bonds to lose value. That could be a concern for retirees and for people using conservative asset mixes in company-sponsored 401(k) plans, which often provide few fixed-income options.

But there are things investors can do to cushion inflation's impact. Those include owning more stocks, holding a diverse mix of bonds and adding certain bonds whose principal value would increase with inflation. Here are some strategies to consider, along with their potential upsides and downsides:

1. Look at what you have

Whether people need inflation insurance depends on what they own. A well-diversified portfolio might already be relatively well protected.

Bond professionals believe the Fed wants the PCE price index to rise to above 2% from its current 1.6%. That would pose the most concern to savers in low-yield bank or money-market accounts, whose yields currently average 0.11%, Bankrate.com says. If that rate didn't change and inflation averaged 2% a year, the purchasing power of a $100,000 account would shrink to about $83,000 after 10 years.

Bonds currently don't offer great returns either, notes Crit Thomas, senior investment strategist at Cincinnati-based Touchstone Investments. But investors in well-diversified intermediate-maturity bond funds can expect to get yields of around 2% to 3%, he says, which, for now at least, should mostly offset inflation.

He cites Touchstone Flexible Income fund (FFSAX) as a tool for earning stable income. According to Morningstar, the intermediate-term bond fund recently had about 37% of its portfolio in corporate bonds. The fund generates a yield of about 2.7% and ranks in the top 8% of its category for the past five years.

For a passive approach, Morningstar gives a favorable review to iShares Core Total USD Bond Market ETF (IUSB), which generates about 2.4% in yield. Unlike the Touchstone fund or its active peers, the ETF's portfolio doesn't change based on a manager's identification of opportunities.

2. Own more stocks, fewer bonds

Some advisers say bonds no longer are a good tool for preserving capital. They not only can lose value if rates rise, but yields of high-quality bonds scarcely compensate investors for inflation. Currently, 10-year Treasurys, which are highly sensitive to rate risk, yield only 1.779%.

Chris Carosa, an adviser in the Rochester, N.Y., area, says because risks are so high relative to returns, people shouldn't keep any money in longer-term bonds that they might need within five years.

For people with longer horizons, owning more stocks is one solution, says Tim Courtney, chief investment officer at Exencial Wealth Advisors in Oklahoma City. Rather than the traditional 60% holding, Mr. Courtney says investors might consider keeping 70% of a portfolio in stocks. Stocks would fare well if inflation averaged around 2% or a little more, he says, though not as well if inflation rose significantly.

The widely held reasoning: As inflation rises more sharply, that tends to make it difficult for companies to raise prices rapidly enough to keep up with rising costs they incur. This eats into profits.

3. Invest in other corners of the world

Global markets move in closer sync than ever, but some foreign economies aren't tracking the U.S. That's a reason to own foreign bonds, says BlackRock's Mr. Rieder, who helps manage BlackRock Global Strategic Bond (MDWIX). Economies in some countries are weak enough, he says, that their central banks might follow policies that will push down interest rates, offering bondholders some opportunities for capital appreciation. He cites Australia, Italy and South Korea as offering such possibilities. Bonds of Mexico and Russia, meanwhile, could appreciate in the event of a commodities recovery, he says.

Many foreign stocks, meanwhile, have higher yields than similar investments in U.S. stocks, says Exencial's Mr. Courtney. He points to foreign real-estate investment trusts, which yield as much as 4.5% a year, versus around 3.5% for U.S. REITs.

Mr. Courtney also expects the dollar to retreat at some point, offering additional benefits for investors overseas. Holders of foreign stocks could see their returns boosted if they sell and convert profits back into dollars, and bond investors could enjoy gains on both return of principal and interest payments.

A low-cost way of adding foreign REITs to a portfolio, Mr. Courtney says, is Vanguard Global ex-U.S. Real Estate Index (VGXRX), which also is available as an ETF ( VNQI). Each owns more than 600 stocks in more than 40 countries.

4. Add some inflation-linked bonds

The U.S. Treasury sells bonds indexed to changes in the consumer-price index, known as Treasury inflation-protected securities, or TIPS. These offer one of the purest forms of inflation protection.

TIPS have been poor performers recently as worries about the economy and the collapse of oil prices crushed inflation expectations. TIPS funds shed about 9% in 2013 and were down around 1.7% last year.

But at current levels, TIPS haven't adjusted to the idea that inflation could top 2% if the Fed stands pat, some say. Daniel Dektar, co-head of Amundi Smith Breeden's Investment Management Group, says investors shouldn't expect "a thrilling return" from TIPS. But if the Fed's preferred inflation measure does edge above 2%, TIPS are likely to outperform conventional Treasurys, and possibly significantly, he adds.

Because TIPS are complex, individuals usually are better off owning them in a fund or ETF. Morningstar Inc. picks include Vanguard Inflation-Protected Securities (VIPSX) and Schwab U.S. TIPS ETF (SCHP).

5. The benefits of corporate credit

Bonds of U.S. companies pay a yield premium, or spread, over Treasurys to compensate for their lower credit standings. That works out to yields of around 2.75% to more than 3% for bonds with low investment-grade ratings such as single-A.

In contrast, high-yield (or junk) bonds may pay more than 7%. But such bonds, which have much lower ratings, can lose a lot of value when markets switch to "risk-off" mode. Early this year, the principal value of some junk bonds fell as much as 10%.

"We aren't telling investors to stay away from high-yield," says Warren Pierson, senior portfolio manager at Robert W. Baird & Co., Milwaukee. Just understand that such bonds have about a 75% correlation to moves in stocks, he says. To get diversification from equities risk, investors need to own highly rated bonds such as Treasurys.

Baird Short-Term Bond (BSBSX), which Mr. Pierson helps manage, recently held about half its portfolio in corporate bonds with an average credit quality of single-A. It yields 1.6% while having an average maturity of less than two years, giving it only modest exposure to a rate rise.

6. A dual role for bank-loan funds

Bank-loan funds, which feature floating rates, have attracted investors looking for protection against rising interest rates. Such funds can serve a dual purpose in an inflationary environment, offering investors potential for both increasing yields and appreciating principal.

Bank-loan funds own loans to companies with low credit ratings, which thus pay higher yields -- rates that float about 5 percentage points above a variable-rate benchmark such as Libor. So, as Libor rises, bank-loan funds eventually pay higher yields -- although under loan terms, there could be a significant lag before that happens. Meanwhile, unlike what happens with bonds, the value of the loans appreciates when yields rise, potentially giving bank-loan fund investors an additional boost. Last year, bank-loan funds as a group had a negative return of slightly more than 1%, compared with about negative 4% for high-yield bond funds.

Among funds rated highly by Morningstar are Lord Abbett Floating Rate (LFRAX) and RidgeWorth Seix Floating Rate High Income (SAMBX). The A shares of each fund yield about 4.4%.

Mr. Pollock is a writer in Ridgewood, N.J. He can be reached at reports@wsj.com.

(END) Dow Jones Newswires

May 09, 2016 02:48 ET (06:48 GMT)

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