Soaring inflation and volatility in bond prices challenge investors

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Investors looking to avoid the double hazard of rising inflation and falling bond prices may feel like they are being asked to navigate the mythological sea creatures Scylla and Charybdis.

On the one hand, global inflation, driven in large part by rising food and energy prices, has reached levels not seen in a generation. Anyone who’s recently walked the aisles of a grocery store or filled their car’s gas tank has felt the pinch. On the other hand, the Federal Reserve has indicated that it may try to curb inflation by reducing its bond purchases and raising interest rates under its control. These moves could reduce the value of existing bonds.

Nonetheless, some bond investors say it is already time for the Fed to act. “We’re starting to get to a point where they should have done it already,” said Rob Daly, director of fixed income at Glenmede Investment Management, a Philadelphia-based fund management firm.

The U.S. Consumer Price Index, which includes volatile food and energy prices, rose 5.3 percent in the 12 months ending in August, the most recent data available. Federal Reserve officials attribute the push to the rapid reopening of the economy and supply chain problems caused by the global pandemic, a situation they say should be “transient.”

Even without preemptive action by the Fed, higher inflation could itself push up new bond yields, as investors expect at least some real return, above the rate of inflation. But as yields and prices move in opposite directions, rising yields would push the prices of existing bonds down.

Dealing with the dual threat of inflation and vulnerable bond prices is difficult, but it should be remembered that even in a bad year, high quality diversified bond portfolios tend to be much more stable than actions. Nonetheless, the current volatile environment for bonds can be worrisome.

John Maloney, CEO of M&R Capital Management, a New York-based fund management firm, preserved the value of his investors’ fixed income portfolios by moving them to ultra-short bond funds, with average durations of less than a year. Duration is a measure of how sensitive the price of a bond is to changes in interest rates or yields; the shorter the duration, the less the price of a bond will be affected.

One of Mr. Maloney’s favorite funds is the JP Morgan Ultra-Short Income Exchange-Traded Fund, which has returned 0.78% in the past 12 months after a management fee of 0.18%. Another is the PIMCO Enhanced Short Maturity Active ETF, which fell 0.48% after a management fee of 0.36%.

The value of these funds fluctuates somewhat, so they may not be suitable for investors with an immediate need to convert them to cash. Still, he said, they’re “a place to get a better return on your money than a money market fund, which pays next to nothing at this point.”

Investors keen to extend the duration of their bond portfolio a little further might want to consider the Vanguard Short-term Corporate Bond Index Fund. ETF and mutual The fund versions have generated a return of approximately 1.7% over the past 12 months and have an average duration of three years.

For those who are already willing to take the risk of holding high yield bonds – also known as junk bonds due to their relatively low credit quality – Kathy Jones, chief fixed income strategist at the Schwab Center for Financial Research, suggested transferring some of these holdings. bank loan funds. As the name suggests, these funds invest in loans made by banks and other financial institutions to businesses. They tend to have a shorter portfolio duration – often measured in just a few months – than high yield bond funds. But in times of downturn, they can be risky.

So, for example, during the panic sell from February 20 to March 23, 2020, at the start of the pandemic, the S&P 500 fell 34%, and bank loan funds and high yield bond funds fell. both fell an average of 20%, according to Morningstar Direct. By comparison, short-term bond funds have lost, on average, less than 5% of their value.

Bank loan funds have fared better, with investors seeking yield over the past year. The T. Rowe Price Floating Rate Fund had a total return of 7.16% for the 12 months ending September 30 and a 12-month return of 3.93%, according to Morningstar Direct. The managers of this fund typically invest 80-90% of the portfolio in bank loans. The expense ratio of the fund is 0.76%.

While shortening the duration of a bond portfolio can dampen shocks from interest rate hikes, it does not directly address the problem of persistent inflation.

“I wouldn’t be a good bond manager if I didn’t say inflation is a concern,” said Adrian Helfert, chief investment officer of multi-asset strategies at Westwood Management, a Dallas-based investment management firm. . “It erodes the future value of an investor’s portfolio.”

A well-used anti-inflationary tool in the bond investor’s kit is the Treasury Inflation Protected Securities, better known as TIPS. The capital of these government-issued securities adjusts for inflation.

The PIMCO Real Return Fund, with holdings primarily in inflation-protected securities, posted a total return of 5.15% over the 12 months to September, after a management fee of 0.87%. The duration of the portfolio is almost eight years.

As concerns about inflation have grown over the past year, investors have pushed up the prices of TIPS and, according to many experts, it is now becoming more difficult to recommend these stocks. The market expects average annual inflation of 2.5% over the next five years. If inflation rates exceed this, then owning TIPS would be more profitable than comparable T-bills. But if inflation is lower than that, investors who own regular Treasuries would fare better.

There is no easy solution, unfortunately.

“What is underestimated by the markets is that it is difficult to fight central banks,” Helfert said. “If the Fed says inflation will be transient, it can make it transient by removing the party’s punch bowl.”


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