Tilting at Inflationary Windmills
Inflation is back, so we are going to talk about what you can do about it within your investment portfolios. For a discussion about what inflation is and whether you should be concerned, read my previous blog here.
The Effect of Inflation on Bonds
Increasing inflation is generally bad for traditional bonds. Remember that the price of a bond is the present value of the future stream of principal and fixed interest payments. As inflation increases, those future dollars are worth less today in real terms. The longer the bonds, the larger the negative impact of rising inflation and interest rates, so one strategy to minimize the impact of inflation on your bond portfolio is to minimize the length or duration of your bonds. There are also other types of bonds which could offset the negative impact of inflation, or even benefit from it because they don’t have fixed future payments. Examples include floating-rate bonds and Treasury Index-Protected Securities (TIPS) which both have interest payments that will go up as inflation and interest rates go up. I have also been asked recently about I-bonds which are government savings bonds with interest payments tied to inflation metrics. These are another possible solution for your portfolio; just keep in mind that there are restrictions on how much you can purchase ($10K per year), and when you can sell them (not before 1 year, and with an interest penalty if before 5 years).
The Effect of Inflation on Stocks
The impact of inflation on stocks is less clear than on bonds. If inflation dampens future economic growth, then the impact could be bad. But if inflation is due to continued strong economic growth, then the inflation will raise prices and overall revenues which can be good for stocks assuming they can control their expenses and maintain profit margins. Note that the impact may not be consistent across all stocks in any period as different industries and sectors may see different results. For instance, higher inflation might be good for a company who has a lot of long-term liabilities because those future payments are not going to be worth as much today. Conversely, a company who is fueling their growth with a lot of short-term debt might be impacted more adversely as the interest they pay on their debt resets upwards each period.
Is Gold a Good Inflation Hedge?
Gold has a reputation as an investment which can hedge against the negative impacts of inflation. However, the historical data is very mixed on whether this reputation is justified. There are a number of drivers of the price of gold so this asset may not react to inflation the way you might expect in any given period. My take is that gold may have a place in your diversified portfolio, but don’t include it only for its supposed benefit as an inflation hedge.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.
Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price. Bond yields are subject to change. Certain call or special redemption features may exist which could impact yield.
Neil Manning, CFP, AIF, CDFA, FSA
I am a reformed actuary turned financial advisor, helping my clients with everything from investments to retirement projections to LTC insurance since 2014. Unlike most normal people, I love numbers and finance – I’m currently reading a book about game theory which my wife and two teenage daughters think is unbelievably boring (they are wrong). For more details about my background, check out my website below.