- Rising inflation and rising interest rates can pose challenges for bonds.
- TIPS adjust as inflation rises.
- Floating-rate loans adjust when interest rates rise.
Inflation has remained at historically low levels over much of the past decade, well below the US Federal Reserve's target of 2%. But that could change. The Fed began raising rates in December 2016 amid expectations for inflation to reach its target—and the central bank expects more rate hikes to come.
History suggests that rising inflation generally is bad news for investors in longer-maturity bonds, for at least 2 related reasons. First, when rising inflation causes price increases, it erodes the purchasing power of future interest payments. What's more, the Fed's main way to keep inflation in check is to boost interest rates—and as rates rise, bond prices fall, and longer maturity bonds tend to see larger price declines than shorter maturity bonds.
Certain types of bonds offer a degree of protection from rising inflation and interest rates, though they come with their own risks. Treasury inflation-protected securities (TIPS) and floating rate loans are structured in ways that help protect against such risks. These securities give investors opportunities to hedge their fixed-income portfolios against declines when rates and inflation increase.
What are Treasury inflation-protected securities?
As their name suggests, Treasury inflation-protected securities, or TIPS, are structured so that their principal value shifts along with inflation. Like other Treasury bonds, TIPS pay interest at a fixed rate every 6 months and repay their principal value on the bond’s maturity date.
However, TIPS' principal value is modified by an inflation factor based on the Consumer Price Index (CPI). When the CPI goes up, TIPS' principal value rises accordingly. Bonds' interest payments are calculated as a percentage of their principal, so when higher inflation pushes up TIPS' principal value, the bonds' interest payments rise as well.
For example, say you purchased TIPS worth $1,000 and the CPI rose by 5% over the subsequent year. The TIPS' principal value would also increase by 5%, to $1,050. The twice-yearly interest payments also would increase, because they would be based on the new, higher principal amount. These adjustments help ensure that the bond’s value and income keep pace with inflation.
TIPS have relatively long maturities, ranging from 5 to 30 years. Prospective TIPS investors should be aware that if deflation occurs, the value of the bond will be adjusted downward, and interest payments will be reduced. What's more, an inflationary environment may also be one where interest rates are rising. This interest rate impact could mean the price of TIPS could fall in the short or medium term, even though the TIPS' principal value is rising. What's more, rates could rise without inflation going up, leaving the principal unchanged but creating a headwind for prices. That said, the Treasury guarantees that you will receive at least the amount of the bond's original principal when it reaches maturity, even if prices have fallen in the meantime.
There are also tax considerations to keep in mind: When TIPS' principal value is adjusted upward because of inflation, the IRS considers the increase to be taxable income.
TIPS can be purchased directly as new issues, or from other investors on the secondary market. TIPS are traded less commonly on the secondary market than other fixed-income securities, contributing to greater volatility than is typical for comparable conventional Treasury bonds. Investors also can invest in TIPS through mutual funds and exchange-traded funds. These funds can offer investors exposure to TIPS with a range of maturities.
The Fidelity.com mutual fund research and ETF research can help you screen for TIPS investing ideas.
|Mutual fund evaluator
Category: Taxable bonds > Treasury Inflation Protected Securities
Fidelity® Inflation-Protected Bond Index
American Century Inflation Adjusted T. Rowe Price Inflation Protected Bond Fund
Theme: Fixed income > U.S. Inflation Protected
ISHARES TIPS BOND ETF (TIP)
VANGUARD SHORT-TERM INFLATION-PROTECTED SECURITIES ETF (VTIP)
SCHWAB U.S. TIPS ETF (SCHP)
FLEXSHARES IBOXX 3-YEAR TARGET DURATION TIPS INDEX FUND (TDTT)
What are floating-rate loans?
Floating-rate loans are also known as leveraged loans, senior secured loans, and bank loans. Banks typically issue these debt obligations to companies that have relatively low credit ratings, and these companies use the loans to finance transactions such as leveraged buyouts, mergers, acquisitions, or similar activities. After the loans are made, they can be bought and sold as securities. Floating-rate loans have yields and volatility similar to high-yield corporate bonds, with one major difference: As their name indicates, their interest rates "float," adjusting periodically based on a benchmark rate, typically the London Interbank Offered Rate (LIBOR). As a result, leveraged loans can offer portfolios some protection in a rising-rate environment.
Floating-rate loans' rates typically reset every 90 days to maintain a predetermined spread to the benchmark rate. This periodic adjustment means that, unlike traditional fixed-income securities, floating-rate loans tend to hold their value when short-term interest rates increase, all else being equal. This benefit can make floating-rate loans an attractive option to help protect a fixed-income portfolio against interest-rate risk.
Investors need to be careful, though. Floating-rate loans' low credit ratings indicate greater potential risk of default relative to investment-grade bonds (though default rates for floating-rate loans historically have been lower than on high-yield bonds). This market may also have liquidity issues, meaning that it may be hard to find a buyer during a negative market event—which could lead to price volatility or make it hard to determine a fair price for one of these securities.
Even so, floating-rate loans offer investors certain protections that conventional bonds don't. Investors holding floating-rate loans are considered preferred creditors relative to the issuer's other obligations: If the issuer defaults, loanholders will be paid before other investors, including bondholders. As a result, floating-rate loans have provided higher average recovery rates in bankruptcies than high-yield bonds.
The market for floating-rate loans was once limited to large investors. That has changed, and now risk-tolerant individual investors can add floating-rate loans to their portfolios through ETFs, mutual funds, and closed-end funds.
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Category: Taxable bonds > Bank loan funds
Fidelity® Floating Rate High Income
T. Rowe Price Floating Rate Fund (PRFRX)
Theme: Fixed income > U.S. Floating Rate
POWERSHARES SENIOR LOAN ETF (BKLN)
VANECK VECTORS INVESTMENT GRADE FLOATING RATE ETF (FLTR)
POWERSHARES VRDO TAX-FREE WEEKLY PORTFOLIO (PVI)
ISHARES TREASURY FLOATING RATE BOND ETF (TFLO)
WISDOMTREE BLOOMBERG FLOATING RATE TREASURY FUND (USFR)
Prepare for uncertainty
TIPS and floating rate loans may help hedge against risks related to rising inflation and interest rates, so investors might want to consider a dedicated allocation to these investments as part of a diversified bond portfolio. Higher inflation and interest rates seem more likely now than they have for some time, so it might be a good time to consider establishing positions in investments that offer the potential for protection against increases in inflation. Bear in mind, however, that many economists and investors have been wrong for years about the direction of interest rates and inflation. The fact is, no one knows the future. Maintaining a diversified portfolio can help you manage that uncertainty, maximizing your ability to achieve your goals.
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