Fixed income that isn't fixed

Bonds may help to manage the risks posed by rising inflation and rising rates.

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Key takeaways

  • 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 been making a comeback. After spending the better part of a decade below the US Federal Reserve's target of 2%, inflation rates have ticked higher in the last 2 years. It's hard to predict what will happen next for inflation, but it may be a good reminder for investors to consider what rising inflation might mean for their bonds holdings.

History suggests that rising inflation generally poses challenges 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 come with risks of their own, but they may 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 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
ETF evaluator
Theme: Fixed income > U.S. Inflation Protected
Source: Mutual fund screen included no-transaction fund fees with expenses in the bottom 2 quintiles of funds only. The ETF screen produced 16 results, only the top results by net assets are shown here. Results as of November, 2018.*

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, though rates may have to rise beyond a minimum before the adjustments kick in. 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.

Mutual fund evaluator
Category: Taxable bonds > Bank loan funds
Fidelity® Floating Rate High Income
Lord Abbett Floating Rate Fund Class A  
T. Rowe Price Floating Rate Fund 

ETF evaluator
Theme: Fixed income > US Floating Rate
Invesco Senior Loan ETF (BKLN)
WisdomTree Bloomberg Floating Rate Treasury Fund (USFR)
iShares Treasury Floating Rate Bond ETF (TFLO)
Invesco VRDO Tax-Free Weekly ETF (PVI)

Source: Mutual fund screen included no-transaction fund fees with expenses in the bottom 2 quintiles of bank loan funds only. The ETF screen produced 5 results, ranked by net assets here. Results as of November, 2018.*

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. Rates and inflation have moved higher, so it might be a good time to review your holding and consider establishing positions in investments that offer the potential for protection against additional 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.

Next steps to consider

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*The Fidelity mutual fund evaluator and ETF screener are research tools provided to help self-directed investors evaluate these types of securities. The criteria and inputs entered are at the sole discretion of the user, and all screens or strategies with preselected criteria (including expert ones) are solely for the convenience of the user. Expert Screeners are provided by independent companies not affiliated with Fidelity. Information supplied or obtained from these screeners is for informational purposes only and should not be considered investment advice or guidance, an offer of or a solicitation of an offer to buy or sell securities, or a recommendation or endorsement by Fidelity of any security or investment strategy. Fidelity does not endorse or adopt any particular investment strategy or approach to screening or evaluating stocks, preferred securities, exchange-traded products, or closed-end funds. Fidelity makes no guarantees that information supplied is accurate, complete, or timely, and does not provide any warranties regarding results obtained from its use. Determine which securities are right for you based on your investment objectives, risk tolerance, financial situation, and other individual factors, and reevaluate them on a periodic basis.
Before investing in any mutual fund or exchange-traded fund, you should consider its investment objectives, risks, charges, and expenses. Contact Fidelity for a prospectus, an offering circular, or, if available, a summary prospectus containing this information. Read it carefully.
This information is intended to be educational and is not tailored to the investment needs of any specific investor.
Information provided in this article is general in nature, is provided for informational purposes only, and should not be construed as investment advice. The views and opinions expressed by the speakers are their own as of November 13, 2017, and do not necessarily represent the views of Fidelity Investments. Any such views are subject to change at any time based on market or other conditions. Fidelity Investments disclaims any liability for any direct or incidental loss incurred by applying any of the information in this article. As with all your investments through Fidelity, you must make your own determination as to whether an investment in any particular security or securities is consistent with your investment objectives, risk tolerance, financial situation, and evaluation of the security. Fidelity is not recommending or endorsing these investments by making this article available to its customers.

Past performance is no guarantee of future results.

In general, the bond market is volatile, and fixed income securities carry interest rate risk. (As interest rates rise, bond prices usually fall, and vice versa. This effect is usually more pronounced for longer-term securities.) Fixed income securities also carry inflation risk and credit and default risks for both issuers and counterparties. Unlike individual bonds, most bond funds do not have a maturity date, so holding them until maturity to avoid losses caused by price volatility is not possible. Any fixed income security sold or redeemed prior to maturity may be subject to loss. Changes in government regulations, changes in interest rates, and economic downturns can have a significant negative effect on issuers in the financial services sector.
Lower yields - Treasury securities typically pay less interest than other securities in exchange for lower default or credit risk. Interest rate risk - Treasuries are susceptible to fluctuations in interest rates, with the degree of volatility increasing with the amount of time until maturity. As rates rise, prices will typically decline. Call risk - Some Treasury securities carry call provisions that allow the bonds to be retired prior to stated maturity. This typically occurs when rates fall. Inflation risk - With relatively low yields, income produced by Treasuries may be lower than the rate of inflation. This does not apply to TIPS, which are inflation protected. Credit or default risk - Investors need to be aware that all bonds have the risk of default. Investors should monitor current events, as well as the ratio of national debt to gross domestic product,
Treasury yields, credit ratings, and the weaknesses of the dollar for signs that default risk may be rising.
Floating-rate loans generally are subject to restrictions on resale. They sometimes trade infrequently in the secondary market, so may be more difficult to value, buy, or sell. A floating-rate loan might not be fully collateralized, which may cause it to decline significantly in value.
Lower-quality debt securities involve greater risk of default or price changes due to potential changes in the credit quality of the issuer.
Investments in mortgage securities are subject to prepayment risk, which can limit the potential for gain during a declining interest rate environment and increase the potential for loss in a rising interest rate environment.
Interest income generated by Treasury bonds and certain securities issued by U.S. territories, possessions, agencies, and instrumentalities is generally exempt from state income tax, but is generally subject to federal income and alternative minimum taxes and may be subject to state alternative minimum taxes.
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