Inflation fighter #2: Setting bonds in motion
As mentioned above, investors typically hold bonds for income and expected diversification benefits versus typical growth-oriented assets. However, an inflationary environment typified by rising rates poses a challenge to static bond investments. Fixed income mutual funds and exchange-traded funds (ETFs) can expose investors to interest rate risk and shifting returns, while individual bonds can lock investors into longer-dated maturities. This outcome will likely become even more worrisome if central banks follow through on their commitment to continue to tighten financial conditions until inflation reverts to the 2% target.
A laddered corporate or municipal bond portfolio consisting of evenly weighted maturities of bonds can help by moving alongside the markets. Laddered bonds regularly experience maturities or a cohort of securities rolling out of their target range, at which point they can be sold. In both cases the proceeds are reinvested at higher interest rates. The ladder structure also takes advantage of a bond’s natural movement down a positively sloped yield curve over time. A laddered fixed income portfolio can also benefit from thoughtful exposure to credit, be it municipal or investment grade. Most importantly, equal weighting should provide attractive long-term returns relative to most passive portfolios.
Inflation fighter #3: Embracing volatility
Inflation eats away at the value of a portfolio over time, requiring investors to earn a higher threshold return just to maintain purchasing power. For this reason, investors in inflationary environments need to seek out opportunities to add an incremental return to their portfolio that ideally exhibits a low correlation to their other assets. Ongoing or reoccurring inflation tends to coincide with increased equity market volatility as investors continually reevaluate a company’s ability to defend its profit margins in a rising cost environment. As volatility rises, so does the demand for protection from market volatility.
Harnessing the volatility risk premium (VRP) may provide one solution to this problem. The VRP is what investors are paid for providing protection against market volatility. Investors willing to bear this risk can add this diversifying and potentially material risk premium to their portfolio to offset some of the negative effects of inflation. The VRP can be introduced into a portfolio on its own or commingled with other assets. Individual investors will ultimately need to determine what solution works best for their needs.
The bottom line
Only the decisions of a few powerful individuals can ease price pressure on investors and consumers worldwide—and even those would need time to take effect. But investors don’t have to wait passively for those decisions to come. They should prepare their portfolios now to withstand continued inflation and other unexpected market events. A diversified, risk-managed, and regularly rebalanced portfolio is an investor’s best defense against whatever the future brings us.
The Bloomberg Commodity Index (BCOM) is formerly known as the Dow Jones-UBS Commodity Index. BCOM is a broadly diversified index composed of futures contracts on physical commodities.