One of the most talked about topics around the world is the rate of inflation and how expensive everyday goods have become. One of the main objectives of investing is having one’s capital keep up with inflation and/or exceed the rate of inflation. As part of one’s investment portfolio, should you keep bonds when the rate of inflation is unusually high? Or when deflation is occurring? Read more about why, or why not investing in bonds is the right move during inflation or deflation.
The cause of the current inflation crisis is a complex topic that is not being helped by the global Covid-19 pandemic, the Ukraine-Russia conflict, and logistical problems. In general, financial professionals agree that a ratio of 60% stocks and 40% bonds in a portfolio is adequate for growing your capital and keeping up with inflation during normal times. However, the 60/40 ratio is recommended during normal times of inflation and not during record-breaking inflation.
Typically, bonds are capital that is lent to a company or government when they need capital. The bonds pay out an interest rate to the investor and after a certain time, the issuer of the bond will then need to pay back the balance, plus the interest. The terms of bonds can vary greatly depending on their uses. Bond terms can have a term of 1 week and up to 40 years. The strategy during periods of high inflation changes what kind of bond terms you invest in.
Since the rate of inflation is ever-changing, investors will need to have short-term bonds in their portfolio that can adapt to the current market, especially when dealing with inflation. There are 2 types of bonds in particular that investors should invest in during periods of high inflation, which are Treasury Inflation-Protected Securities (TIPS) and I bonds. Although they are all offered by the US Treasury, they are different from one another, and they have their benefits.
TIPS are not like typical bonds where the interest rates remain the same throughout the bond’s terms. Instead, the interest rates in TIPS adapt to take into account the current rate of inflation. They also take into account the Consumer Price Index (CPI) indirectly when principal values are adjusted, and the interest payments of the TIPS are also adjusted. The only major downside of investing in TIPS is their tax disadvantage, as investors are required to pay a tax on income payments and on the inflation adjustments that are made to principle values.
I bonds are similar to TIPS in that they change their interest payments based on the inflation rate, but have a slight difference. I bonds give their investors a fixed interest rate plus an additional interest rate that varies based on the inflation rate that is measured by the CPI. The additional interest rate that varies is adjusted twice a year.
One of the biggest benefits of investing in I bonds is they are considered to be high real yields, offering their investors safety when it comes to inflation. There are two main negatives when it comes to I bonds, which are investors are only limited to purchasing $10,000 of I bonds per year plus $5,000 per year of I bonds via tax refunds. The biggest negative of I bonds is that unlike other types of bonds, they do not payout their interest rates biannually or quarterly. Instead, they pay their interest after maturity. Investors can cash the bonds after 12 months of ownership and if redeemed within 5 years, you will have to give up 3 months of interest.
Both I bonds and TIPS would make great investments during a recession. This is especially true considering that they are bonds that come with the typical benefits of investing in bonds, such as stability and predictability. Other types of bonds do not adapt to the rise of inflation nor do they take into account the CPI. Another type of bond that would make a great choice is investment-grade corporate bonds.
The reason why some corporate bonds make a good investment is that they are issued by companies with incredibly high credit ratings. Just like individuals, companies also have credit ratings. Credit ratings that are higher than BBB- with Standard & Poor’s and a Baaa3 with Moody’s are considered Investment-grade corporate bonds. Corporate bonds will offer higher returns than government bonds, but also come with a slightly elevated risk.
Inflation is when the prices of everyday goods and services increase, which is a phenomenon that is talked about around the world. The opposite of inflation is deflation, which is when the costs of everyday life start to decline, a relatively rare phenomenon. The last time deflation occurred in the United States was during the great depression in the 1930s and periods of deflation do not typically last a long time.
Investment-grade bonds, as mentioned above, would make great investments during deflation. The reason why investment-grade bonds are a better proposition than government bonds is due to the returns. Some government bonds have incredibly low interest rates, while corporate bonds offer higher rates, albeit at higher risks as well. This is why it is advisable to stay with high-quality companies that are regarded as blue-chip investments.
Another type of investment that would make a good addition to a portfolio is shares in companies that offer essential goods and everyday staples. No matter the economic situation, essential goods will always remain essential and in demand. In normal circumstances, having an account with cash is often seen as an unused investment capital that is losing value daily due to inflation.
However, having cash during a deflationary period is a viable option, but not the best option. The reason why this is true is due to the costs of everyday goods and services declining and as a result, the cash you have will allow you to purchase more of those goods and services in the future. Keep in mind that it is almost always better to have your cash in traditional investments. This is only true during periods of deflation.
When it comes to protecting your capital from inflation, only certain bonds make a great investment, which are I bonds and TIPS. Other types of bonds can alleviate the impact of inflation, but not to the extent of I bonds and TIPS. There are also investment-grade bonds that investors can choose from but come with elevated risk levels.
Investors can benefit from investment-grade bonds during deflation and from shares of companies that sell essential goods and services. In general, bonds would make a great investment during periods of inflation and deflation, but it is limited to only some types of bonds. I bonds, TIPS, and investment-grade bonds would be perfect choices. Investors should worry more about the rate of inflation than the rate of deflation as it is quite rare.
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