Ecology of Money

Bubble-Proofing Your Bond Portfolio

John F. Wasik

Are you tired of the myriad predictions on how inflation will come roaring back? As we lumber through our jobless recovery and economic malaise, the inflation hawks are beginning to sound like Chicken Littles.

The sky isn't falling--yet. You can rest assured, though, that inflation will return in some form, and you need to prepare for it. We also may be in the midst of a bond bubble, and you don't want to be neck-deep in long-maturity issues when the bursting sound is heard around the world.

It's a good time to review your income portfolio, anyway. Financial planners find that most conservative investors are not diversified when it comes to income and highly vulnerable to interest-rate risk. When rates begin to climb, current bonds will lose value as investors run to the higher-yielding notes.

How will you know when the inflation riptide is coming? Some of the warnings have already been sounded, although they may be false alerts.

Jack Ablin, chief investment officer of Harris Private Bank in Chicago, notes that recent record-setting gold prices are a conventional harbinger of global inflation. But the yellow metal should not be viewed in isolation. Gold has been rising while major currencies have been falling. As sovereign debt woes mount across the world--the U.S. alone has a $13 trillion debt--gold acts as a universal refuge. But don't place all of your bets on gold. It may be in a bubble of its own.

"Gold is a good proxy for inflation," say Ablin. "But it may be a head fake. If there's a bubble in gold, there also may be a bubble in commodities."

Like most of the wisest advisors, Ablin cautions investors from concentrating money in only one or two asset classes in an effort to time the market and inflation resurgence. Few people can predict when the deleveraging of the world economy will end.

Ablin suggests watching the government's Producer Price Index, which is what producers receive for their goods on the wholesale level. This gauge could give an earlier heads-up of an inflationary surge before it shows up in the widely followed Consumer Price Index. Another good fog horn is the Dow Jones/UBS Commodity Index, which tracks a basket of commodities. Rising prices of raw materials can trigger higher consumer prices and interest-rate hikes.

The worst strategy is to bunch up your assets in a handful of investments such as government or corporate bonds. You'll need a broad mix of income-producers to not only protect against inflation, but provide more reliable income. Here are some suggestions for diversification:

  • Treasury Inflation-Protected Securities. TIPS offer explicit protection against inflation because their principal value adjusts along with the inflation rate, as measured by the Consumer Price Index. Individual TIPS can be purchased directly through TreasuryDirect or through a mutual fund, such as  Vanguard Inflation-Protected Securities  (VIPSX), which is a good, low-cost option.
  • Investment Grade Corporate Bonds. You can buy these in mutual funds or ETFs or individually from brokers. The  Vanguard Total Bond Market ETF (BND) gives you a wide sampling of this market, while  Vanguard Intermediate-Term Investment-Grade (VFICX) offers dedicated corporate bond exposure.
  • Floating-Rate Bank Loans. Funds pool these loans, whose interest rates adjust along with that of a given benchmark, such as the LIBOR. That should hold them in good stead if rates head up, and bank-loan funds also tend to hold up well in inflationary environments. But note that these securities are also characterized by more credit risk, so investors should know what they are buying into. One of Morningstar's favorite funds in this category is  Fidelity Floating Rate High Income (FFRHX).
  • International Bonds. Issued outside of the U.S., these bonds may have higher yields, although they also contain currency risk and may court more credit risk as well. A fund like the  SPDR Barclays Capital International Treasury (BWX) provides access to a broad basket of international government bonds.
  • Real Estate Investment Trusts. These are exchange-listed companies that own real estate and pay out the majority of their rent income and profits to shareholders. The  Vanguard REIT Index ETF (VNQ) is one low-cost choice.
  • High-Yield Corporate Bonds. As the riskiest of corporate bonds, these securities also pay the highest yields. The  SPDR Barclays High Yield Bond ETF (JNK) is one low-cost "junk" bond vehicle.
  • Convertibles. These hybrid securities pay income and can be converted to stocks at a later date. The SPDR Barclays Convertible Securities ETF (CWB) is a worthy choice.
  • Equity-Income/High Dividend Stocks. Consider seeking out funds that invest in solid companies that pay regular dividends, such as  Vanguard High Dividend Yield ETF (VIG), which provides a wide sampling of such firms.

As you can see, not all of these asset classes are conventional bonds. The idea here is that they all don't move together and could do better than holding most of your money in a 10-year Treasury note, which has been yielding around 2.5%. Also keep in mind that these assets have a different risk profile than Treasuries, so you'll want to be sure that your final combination of income-producing assets is in line with your investing time horizon and risk tolerance.

As an alternative, you could simply buy an "all-in-one fund" such as the  PIMCO Diversified Income Fund (PDVAX). Be apprised that no one income strategy will suit all investors and all situations. There's always credit risk and the possibility of another worldwide meltdown, which wallops stocks, junk bonds, and any corporate issues and would benefit Treasuries. That's why it pays to have more than one umbrella when the inflationary rain starts to fall.

John F. Wasik is a Morningstar columnist and author of 13 books, including The Cul-de-Sac Syndrome: Turning Around the Unsustainable American Dream. The views expressed in this article do not necessarily reflect the views of

John F. Wasik does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.