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Rekenthaler Report

Fixed-Income Investing When Inflation Is Dormant

Insuring against the possibility of change.

Regime Change
In 1996, I took a "Money and Banking" seminar from a British professor who had previously worked at the Bank of England. He left me with two abiding lessons. One was that the leading central banks are powerful, but the marketplace, when unified, is stronger yet. (He had been on the receiving end in 1992, when the market's short sellers forced the British government to devalue the pound.) The other related moral was that hyperinflation is just around the corner.

The syllabus emphasized the ravages of inflation, caused by printing too much money to appease the masses, or by being held hostage to foreign currencies. The former condition self-evidently breeds inflation, while the latter creates a vicious cycle. Short sellers weaken the nation's currency, thereby increasing its debt burden, thereby tempting the country to print more money, thereby further weakening its currency. Down the rabbit hole the unfortunates descend.

(From what I gather when talking to former classmates, remembering but two concepts from a session that involved 100-plus hours of labor is par for the course. It may even be a birdie. That thought disturbs me when I visit doctors.)

Since that time, inflation has pretty much disappeared. Per the World Bank, at last report only two infamously ravaged countries (South Sudan and Venezuela) had annual inflation rates exceeding 100%. Most emerging counties were under 10%. The major economies were lower yet, with the United Kingdom being the highest of the developed markets, at a puny 2.6%. The demon has been silenced.

Bad Math
Whether inflation's defeat is permanent, because politicians have learned to heed their economists, or is merely temporary remains unclear. What does seem apparent, at least to this writer, is that retirees should continue to guard against the threat. Today's good news might persist--but it might not. If so, woe to those who rely upon fixed income.

For example, 30 years of 2% annual inflation erodes almost half the value of a nominal monthly payment.

Typically, retirees can live with that loss, because they also possess financial assets (Social Security receipts, possibly some equities) that resist inflation, and because most are less active over time. Fifteen years into retirement, a 2% annual inflation rate will consume $0.26 of each fixed-income dollar--painful, but as one segment of a larger portfolio, probably manageable.

However, the math worsens rapidly as inflation increases. Five percent annual inflation destroys $0.54 on the dollar in 15 years, and 79% after 30 years. At 8%--a level that the U.S. averaged for a full decade, from the early 1970s until the early 1980s--the fixed-income investor drops 92% of the asset's value over three decades.

Bonds to Bills?
The 30-year Treasury bond's yield of 2.6% indicates that the marketplace regards such possibilities as remote. The market's judgment deserves respect. Time and time again, it has embarrassed those who have decried its valuations as being "market bubbles." Six years ago, I disagreed with the contention that bonds were in a bubble, and I continue to disagree today. That said, the probability that inflation will ultimately punish bond owners is non-zero. Safeguarding against the event is prudent.

One form of defense is staying short. Three-month Treasuries now pay 2.3%, more than 10-year notes and almost as much as the long bond. At least for government-guaranteed securities--corporates are a different matter--bond investors can have their cake and eat it, too. They can match their income by swapping from bonds to bills, while being largely immune from inflation spikes.

The catch, of course, is that things change. Short-term yields are competitive today, but they may not be competitive tomorrow. Also, that seemingly free lunch often comes with a hidden cost, because it signals that bonds will soon rally. In which case, those who swapped bonds for bills sold for relatively low prices, and if they later wish to lengthen their portfolios, they will need to buy high.

Consider, for example, the chart below, which portrays the yield on 10-year Treasuries, minus the yield on two-year notes. That sum is nearly always positive, reflecting the extra inflation risk carried by the longer issue. In four of the previous 25 years did the spread approach (or fall below) zero: 1995, 1998, 2000, and 2006. On all four occasions, bonds promptly rallied.

Thus, although this would appear to be an opportune time to insure against inflation by exchanging long securities for short, the opportunity cost might be steep. (It seems odd that one could wax nostalgic for a 2.6% yield, but stranger things than that have occurred in this decade's bond market.) Best to adopt that tactic in moderation.

Considering TIPS
The other safeguard comes from inflation-protected securities, which for the most part consist of government-issued Treasury Inflation-Protected Securities. As Morningstar's Maciej Kowara has written, TIPS are more of an insurance policy than an asset class. They have gained only about 3.5% annually over the past decade and are unlikely to fare much better heading forward. However, they fulfill a role. Over time--they can be quirky in the short term--TIPS will counteract the effects of inflation.

By recent standards, TIPS are neither attractively nor unattractively priced. In their early days, they offered higher real yields (that is, the amount that is added to the computed inflation rate, to arrive at the security's full payment) than they now do. That said, at least current real yields beat their 2015 and 2016 lows, and they are far above 2012-13 levels, when they temporarily went negative. Call it a draw.

As with Treasury bills, TIPS should generally be purchased cautiously, not aggressively. The same caveat about the danger of opportunity cost applies to TIPS as with Treasury bills. Perhaps 25%? Placing half of one's fixed-income assets into intermediate to long bonds and dividing the other half between TIPS and Treasuries seems a reasonable approach to me. Such a strategy offers decent inflation protection, while not foregoing all the benefits that come from owning long nominal bonds.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.