Investors are worried about inflation. How bonds can help

Bonds are typically thought of as the safer part of an investors’ portfolio — a form of protection when the stock market gets unruly.

Yet as inflation becomes a growing concern, that form of security is looking a little wobbly.

“One of the single greatest concerns to bondholders is inflation,” said certified financial planner Andy Mardock, founder and president of ViviFi Planning in Bend, Oregon, and a member of the National Association of Personal Financial Advisors.

The reason for that is simple, he said.

When you buy a bond, you’re lending a company or the government your money in exchange for a promised fixed rate of return, which is based, in part, on expectations of inflation. If those expectations are exceeded — in other words, if inflation picks up more than anticipated — that agreed upon return becomes less attractive.

“If you lend money for 2% interest per year but inflation turns out to be 3%, the end result is a loss of 1% in terms of what you can buy with your money,” Mardock said. “Add taxes on top, and the effective loss grows.”

When prices start to steeply rise, many investors prefer stocks to bonds because they tend to offer higher returns. The S&P 500 has outpaced the Morningstar Core Bond Index in nearly every three-month rolling period over the past 10 years, according to Eric Jacobson, a strategist at Morningstar.

“As inflation emerges, companies often have the ability to pass those costs along to customers in the form of higher prices,” Mardock said. “In this scenario, it’s better to be an owner than a lender.”

Alex Doll, a CFP and president of Anfield Wealth Management in Cleveland, said it’s been hard to ignore the market’s recent growth amid inflation fears. Between January 2020 and June 2020, the S&P 500 rose more than 23%.

“With bonds yielding almost nothing and the stock market looking stronger and stronger, we moved some of the fixed income allocation into value and quality stocks rather than sit in a bond fund and earn 1%,” Doll said.

But Jacobson said people get fed up too quickly with bonds.

“The problem comes when there is a crisis,” Jacobson said. “Back in 2008, when we had the financial crisis, the only thing that saved a lot of people were their bond allocations.”

Recently, Jacobson found that even though U.S. Treasury bonds have returned just around 3% a year to investors over the past decade, they make up a quarter or more of many of the bond funds tracked by Morningstar.

That’s because when the markets sour, these government bonds tend to act as an insurance policy. For example, when the S&P 500 was down by more than 20% between February and March 2020, a 10-year Treasury note was up 8%, according to calculations by Jacobson.

“When investors are fearful, either of recession or a broad market crisis of some kind, they tend to make a so-called flight to quality,” Jacobson said. “When that happens, they’re usually seeking the most liquid, safest asset available, and that’s universally considered to be U.S. Treasurys.”

Overall, more conservative portfolios tend to recover faster from downturns than more aggressive ones.

A portfolio with more than 70% stocks and the rest in bonds and cash took more than two years to recover from the financial crisis, compared with just seven months for a portfolio with more than 70% in bonds and cash and the rest in stocks, according to calculations provided by Charles Schwab.

Investors nearing a particular goal or retirees who need to live off their portfolio will want to pay extra attention to that history.

“Your bond allocation will keep your retirement cash flow stable, even during particularly difficult times in the stock market,” said Benjamin J. Brandt, a CFP and president of Capital City Wealth Management in Bismarck, North Dakota.

There also are some bonds that are specifically designed to protect investors against rising prices.

Those include Treasury inflation-protected securities, or TIPS, and Series I bonds, both of which increase with inflation.

There are a few key differences between the two, though, Mardock said. TIPS have a maturity date, while Series I bonds can be redeemed at any time, although the latter can’t be sold for a year after being purchased, and are subject to a three-month interest penalty for five years.

“Aside from redemption limitations, I consider Series I bonds to be more conservative than TIPS while still providing some helpful inflation protection,” Mardock said.

Both could become a more valuable part of people’s fixed income portfolios, Doll said.

“Because inflation has been so low over the past few years, many people have forgotten about them,” he said.