Bonds package and sell debt to investors as fixed-income securities. Investors get a reliable income stream with reduced risk, which can act as a long-term cash source — or a stabilizer for a portfolio focused on higher-risk, higher-reward investments such as stocks.
But while bonds don’t have the same kind of return volatility as stocks, they are vulnerable to one major macroeconomic force: inflation. High inflation can consume the income from a bond in the same way as it eats up pensions and savings, rendering them worth less — or in extreme cases, worthless.
Nominal vs. real returns: the inflationary threat to bond incomes
The cause of this is the yawning gap between nominal and real returns. To make this clear, imagine a bond that pays off in a century. Bought in 1922 for $136, it delivers this year. Its yield is pretty spectacular: 1000%. When it’s cashed in it will put $1,360 in your hand. That sounds good: it’s a very high nominal rate of return. But there’s more to the picture. $1.36 in 1922 money is $32.47 in today’s. This high nominal rate of return is actually a negative real rate of return, once inflation is factored in.
Right now, inflation is surging off the back of the Federal Reserve’s inflation of the bond market during the Coronavirus pandemic — at the same time as tapering that support makes money markets around the world uneasy.
At the same time, the income that inflation is corroding is already historically low; in an interview discussing a problem “that has confounded advisors for more than a decade: the search for income”, DPL Financial Partners Founder and CEO David Lau describes historic low incomes across investments in “a low rate era – not low-rate environment at this point, but era”.
Reuters’ David Randall concurs, noting that bond returns are at their lowest ebb for 40 years.
Rising yields and falling prices as the Fed tapers
However, these facts don’t tell the whole story. Bond yields are climbing rapidly in the short term, largely in response to the US Federal Reserve’s taper. They’re just limbing fast from a low floor. In the last year they’ve risen to 2.77% on US Treasury notes, a significant jump from last year’s 33¢ on the same bonds; but historic norms are around 5.1% for the same notes.
So the challenge for investors and advisors is to make sense of a market that’s simultaneously underperforming its own historic norms, and outperforming the rest of the traditional investment market for income investors. In particular, bonds now significantly outperform stocks for income investors, and that’s likely to remain the case for the rest of 2022, according to Max Wasserman, founder and senior portfolio manager at Miramar Capital. “Yields look to be in the process of peaking”, says Wasserman, “and that high should be in place this quarter”.
Across the world, central banks are raising their interest rates to deal with inflation, moves that could benefit the bond market; as the Fed teases the idea of a .75-point raise, the National Bank of Australia raised its own rates 0.5%.
A tale of two bond markets
Of course, all investors don’t face the same challenges. Bond investors typically fall into two groups: those concerned with yield over a specific time, say with the five-year yield, can make hay in the current market, paying lower bond prices for higher yields at three and five years. This group typically involves relatively small-scale and individual investors, for whom the major disincentive is the requirement to hold bonds to term and thus lock up their capital.
They’re not the only bond investors, though. In fact, they’re not the largest group. That’s institutional investors such as pension funds and portfolio managers, whose key concern is total returns, whenever they might come in. Since total returns are falling as interest rates climb, these investors struggle with the bond market as well as, increasingly, with the stock market.
Bonds deliver a payoff in two ways. Fixed-period bonds that mature in three, five, or ten years are the norm. During that period, they deliver interest payments, known as coupons, for the duration of the bond’s life, usually twice a year. At the end of the bond’s life, it matures, and whoever holds it at that point is entitled to a principal payment. Typically, individual investors are more interested in the coupon, and long-term investors more interested in the principal. Once bonds have been issued, usually in sales to individual investors seeking reliable income, they often join a secondary market where their price is determined by a mix of face value, the value of remaining coupon payments, and the value of the principal, combined with the purchaser’s views on where inflation (and thus the value of bond income) is going next.
Where should investors be looking for income in the bond market now? One option is inflation-linked bonds. These are issued by agencies in the US, Canada, India and several other countries, and have historically been a popular investment vehicle for long-term investors whose focus is on total yield.
Inflation-linked bonds are tied to the costs of consumer goods as measured in inflation indexes like the Consumer Price Index (CPI), which assesses the cost of a basket of goods in order to gauge the purchasing power of the currency. These are constructed and measured differently in different countries, so caution is advised.
In the United States, Treasury Inflation-Protected Securities (TIPS) and inflation-indexed savings bonds (I-bonds) are tied to the value of the US CPI, and offered for sale by the US Treasury. In Canada, they’re offered by the Bank of Canada; in the United Kingdom, it’s the Debt Management Office that sells bonds linked to the Retail Price INdex. Canadian inflation-linked bonds are courtesy of the Bank of Canada; India issues its equivalent through the Reserve Bank of India.
Inflation-linked bonds work by yoking the principal of the bond to inflation, meaning the face value of the bond rises when inflation occurs. This means they’re often preferred in high-inflation periods, when the value of other securities investments tends to fall. The interest paid out on inflation-linked bonds is also adjusted for inflation, softening the impact of reduced purchasing power, particularly for long-term investors.
Risks, taxation and Tips
Inflation-linked bonds aren’t risk-free; their value fluctuates with interest rates, and they often offer poor protection against deflation. The US Treasury sets an initial floor for its TIPS at issue face value, but older TIPS issues can carry years of inflation-adjusted accruals which can be lost to inflation, wiping out value when purchasing power rises. This caused TIPS to underperform the rest of the bond market during 2008, for instance.
TIPS have two values: their original face value, and the current value adjusted for inflation. These adjustments of principal value based on inflation are considered income in some jurisdictions and tasked accordingly; the picture is further complicated by the fact that holder’s don’t actually receive this additional cash: they receive larger coupon payments and only get the inflation-augmented principal when the bond matures. This means bond holders can wind up paying tax on money they’ve never seen, so-called “phantom income”.
ETFs in the bond market
Inflation-linked bonds aren’t risk-free, but in a period of low earnings and projected high inflation, they’re an option. They’re not the only one. It’s worth considering ETFs (Electronically-Traded Funds) too.
Some TIPS are packaged as ETFs, such as the Schwab US TIPS ETF, commonly selected by robo-advisors because of its predictability and solidity. Others are international ETFs that behave like TIPS without national borders; diversified into multiple jurisdictions and markets, they can offer a more stable approach to income-oriented investment. The SPDR FTSE International Government Inflation-Protected Bond ETF is one such bond, designed to hedge against inflation outside the US while reducing exposure to it on the domestic market.
In addition, unpackaged government bonds shouldn’t be discounted. Andy McCormick, head of Global Fixed Income at T. Rowe Price, told US News that said his funds have been buying 10-year Treasuries, gauging that much of the Fed’s tightening is already priced in.