Let’s face it; there are few things in the world that have the potential to destroy the value of your assets like inflation. And what makes inflation particularly dangerous is the insidious way it slowly erodes the value of money – often without us even noticing.
We should face another fact as well: no one really knows how high inflation will be or when it will finally abate. We do know however, that year-to-date 2022, inflation has exceeded 8% annually. But what does this mean to you?
Understanding inflation’s effect on your bonds
Let’s take a simple exercise for a 65-year-old saver who puts $1 million into a 10-year U.S. Treasury note today yielding 3.5% and maturing in 2032. At maturity our saver will have $1.4 million – but if inflation persists at just 6%, the buying power of that $1.4M will be precisely the same as $760,000 in today’s dollars. Prepare for a 24% reduction in lifestyle if you’re depending on that money at age 75.
But it gets worse – much worse – if our saver is depending on the $35,000 of annual income that’s being generated by the Treasury note from age 65 to 75. In that case, our investor still has $1 million at 75, but the buying power of that money has dropped to under $540,000 in today’s dollars, assuming inflation has continued to run at 6%. Inflation is indeed one of the great challenges to a financial plan and good solutions are often difficult to find.
Beware of ‘the pet rock’ and other inflation ‘solutions’
Conventional wisdom says to buy gold to protect yourself from inflation. And while this may work on paper, gold produces no income (It’s basically a pet rock!) and plays no reliable role in a financial plan which is designed to access the value of a lifetime of asset accumulation.
Holding onto very short-term investments, such as money market funds or 30-day Treasury bills, is another commonly accepted strategy to fight inflation. Here again however, there is very little income available to access – money market rates are at about 2% currently – and inflation is continuing to eat away at the buying power of your savings in a substantial way.
Better strategies to guard against inflation
Are there any good options when the prospect of lingering inflation looms? Fortunately, several strategies can be highly effective:
- Curate a portfolio of creditworthy bonds paying above-market rates. Treasuries aren’t the only option investors have, and those with patience and experience can often find opportunities to invest at rates significantly above the general market.
- Hold floating-rate debt. Many floating-rate securities make quarterly payments that reset in “real time” to prevailing interest rates. In other words, the bond’s income will track higher when inflation tracks higher. This structure can significantly protect against erosion of buying power.
- Buy discounted bonds. High-quality bonds which trade at a discount to par value often hold the potential for capital appreciation. Discounted bonds have the potential to produce the best of both worlds: income available for distribution, and capital appreciation to offset the effects of inflation.
Inflation is a formidable challenge. Still, there are ways for bond investors to protect the real value of their assets and to maintain a meaningful stream of distributable income.
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