Fixed-income and inflation go hand-in-hand like termites to wood–inflation can erode the profits of fixed-income investments over time. Furthermore, the extended bull market has seen inflation on a steady, upward path with an increase of 2.9% for the 12 months ending July 2018, which is up from 1.9% since last August.
“Inflation and fixed income are not a good combination usually,” said George Rusnak, co-head of global fixed-income strategy at Wells Fargo. “Inflation eats away at your returns, and if your return is fixed in nature, it erodes quickly.”
However, investors can take core measures to shore up their fixed-income investments in the face of rising inflation through diversification strategies in three exchange-traded funds.
1. SPDR Blmbg Barclays Inv Grd Flt Rt ETF (NYSEArca: FLRN)
To help outpace inflation, especially during a rising interest rate environment, an investor can try and beat it at its own game via ETFs that feature a floating rate component. With every short-term rate adjustment that the Federal Reserve decides to incorporate, the yields on debt issues that feature a floating rate effectively hedge against these rate spikes.
FLRN seeks to provide investment results that mimic the performance of the Bloomberg Barclays U.S. Dollar Floating Rate Note < 5 Years Index. At least 80 percent of assets will go towards securities that include U.S. dollar-denominated, investment grade floating rate notes. This floating rate component can take advantage of short-term rate adjustments by the Federal Reserve, while at the same time, protect the investor against credit risk with investment-grade issues and a duration of less than five years.
2. IQ Real Return ETF (NYSEArca: CPI)
While floating rate corporate bond ETFs provide the necessary hedge against a rising rate environment, rising inflation can tamp down any returns realized from floating rate corporate bonds. As such, investors are keen to supplement floating rate bond ETFs with inflation ETFs like the IQ Real Return ETF (NYSEArca: CPI) as an option to hedge against inflation.
CPI seeks investment results that correspond to the IQ Real Return Index–a “fund of funds” that invests its net assets in the investments incorporated within the underlying index. Fixed-income investors using corporate bond ETFs are subject to duration risk tied to interest rates, but in an economic environment where inflation is also rising, an ETF like CPI would be of benefit.
Furthermore, corporate bond ETFs that invest in debt issues featuring a floating rate component are also subject to credit risk as the bonds are typically tied to companies that are below investment-grade. This poses a risk to investors, particularly since companies tied to below investment-grade debt have a higher propensity to default.
“CPI is incorporated into portfolios specifically to provide a real return over inflation, without relying purely on duration,” Salvatore Bruno, Chief Investment Officer of IndexIQ, told ETF Trends. “Therefore, inflation is the primary driver of return and risk for the strategy. We see more conservative portions of the portfolio go to CPI compared to corporate bond or floating rate positions. We see cash being incorporated more into portfolios not for liquidity needs, but because investors do not find a suitable strategy that provides a real return over inflation without a significant reliance on duration.”
3. SPDR Blmbg BarclaysST HY Bd ETF (NYSEArca: SJNK)
Adding a mix of high yield bond ETFs could be akin to a nitrous oxide injection when racing against inflation. High-yield bond strategies led a Morningstar Inc list of top fixed-income performers during the second quarter, taking seven out of the 10 spots.
All in all, high-yield bond strategies have been outperforming their investment-grade counterparts by an average of 2%. SJNK seeks to provide investment results that correspond generally to the price and yield performance of the Bloomberg Barclays US High Yield 350mn Cash Pay 0-5 Yr 2% Capped Index.
SJNK invests its total assets in the securities comprising the index, which is designed to measure the performance of short-term publicly issued U.S. dollar-denominated high yield corporate bonds. The short-term maturities will help hedge some credit risk due to the lesser exposure, but holdings are still less than investment-grade. SJNK has returned 1.20% year-to-date, 2.94% the past year and 3.76% the last three years.
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