Building an Inflation-Fighter Bond Portfolio

Christine Benz: Hi. I'm Christine Benz for Morningstar. Even though inflation is well under control currently, investors ignore it at their own peril. Marta Norton, an Investment Manager in Morningstar's Investment Services Group recently wrote an article that included a model portfolio for fixed income investors looking for inflation protection, and she is here to talk about it with us today.

Marta, thanks for joining us.

Marta Norton: Thanks for having me, Christine.

Benz: So, Marta, this portfolio includes 40% in a core global bond, 20% TIPS, 15% bank loans, 10% high-yield, 10% convertibles and 5% emerging-markets currency.

So, my question is, you usually think of TIPS as being the really obvious place to start when adding inflation protection to a fixed income portfolio, but you didn't just stop there, you think investors need to broaden their toolkit a little bit.

So, why do you think investors should look beyond just TIPS?

Norton: Sure. Well, TIPS certainly are the obvious choice when it comes to fixed income and the desire to fight inflation. But in this case, we think TIPS are somewhat of an unattractive market. Real yields are at historically low levels, and that means that investors might be getting compensated for inflation when they go to TIPS, but they're not finding much protection from, say, the threat of rising interest rates or from concerns about the economy or the federal deficit.

So we think even the investor perception of these concerns, even if that worsens, TIPS yields could spike and that would hurt bond prices there. So, when we think about inflation, we're not just thinking about TIPS as a form of protection.

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Benz: And when investors are thinking about TIPS and looking at their performance, the past performance might not be a good lens through which to view future performance.

Norton: Definitely not. I think TIPS in the treasury market, in general, has really benefited from a flight to safety and you can't think that that's going to go on in perpetuity.

Benz: So, for the core exposure in a portfolio that is set up to defend against inflation, you've got a global holding versus one that would be a U.S.-focused, say, bond market index fund. Why is that? Why do you think investors should think globally?

Norton: We did look to the global mandate, and I think it's fair to say that we like global mandates across the boards. We like them in equity and fixed income. We like to broaden our opportunities side when we think about investing. So that's something that you'd see in all our portfolios. But I think when you think about inflation, a global mandate is even more important, because what a lot of people are concerned about is U.S. inflation, and if you have troubles at home, it makes sense to go abroad.

But when you are doing this, I think you have to be aware that some of the issues that are facing the U.S. are just as prevalent in other countries.

Benz: Certainly in Europe.

Norton: Right, when we saw that this spring. And even if you look to emerging markets, I mean these countries are billed as far healthier than the developed markets. If you think of China and Brazil, a lot of these countries weathered the downturn a lot better and earn pretty strong economic position. But those markets can overheat; they can have inflation of their own. So, when we look to the global bond market, we really stick with managers who we think can understand those dynamics and really pick the best areas to invest.

Benz: So one think I want to talk to you about, Marta, is the bank loan, slice of this portfolio, about 15% of the portfolio in bank loans. These are credit-sensitive securities, but they also have floating rates. So talk about why you think that they might make sense as an inflation protection measure in a bond portfolio?

Norton: Sure. Well, the trouble in the fixed income market or at least for the traditional bonds is that you have a fixed investment, and so your fixed coupon payments, the fixed principal, and inflation can eat away at that. When you have bank loans you are tying your coupon payments to the LIBOR or the interest rate that banks charge one another, and that rate can tick up and interest rates usually rise in inflationary periods. So your coupon payment would be climbing as well and that offers its own protection.

But you raise a good point. I mean we're looking at protecting a portfolio from inflation, but we're introducing some credit exposure here. You really can't have something for nothing. So when you are looking at the bank loan space, you really have to consider the credit risks that you are having. We think that the market is actually pretty broad and that you can find managers who focus very much on the health of the issuer and the covenants of the bonds and actually can find some secure issues there.

Benz: You just need to shop carefully because some of these really bombed in 2008.

Norton: That's right.

Benz: I also wanted to talk a little bit about high-yield. I'm assuming the thinking is similar. Obviously, you don't have that floating rate element, but you do have that credit sensitivity and maybe a little bit of imperviousness from rising interest rates?

Norton: That's right. So you have a fatter yield. So, inflation is going to take a smaller slice out of a high-yield coupon than it would at bonds and the investment grade market. But again, the credit risk is something that you have to be cognizant of and the managers or the fund managers that we like are the ones who focus very much on the financials, the ability, the willingness of the issuer to pay, the protection within the bond in the form of its covenants to protect investors from any downgrade or to fight risk or even economic retrenchment.

Benz: Okay. Well, thank you, Marta, the interesting article, thanks for sharing your ideas with us.

Norton: Great. Thanks for having me.

Benz: Thanks for joining me. I'm Christine Benz for Morningstar.com