In early 2022, bonds have found themselves at a crossroads. While traditionally a safe haven when the stock market is selling off, bonds are facing their own challenges in the face of high inflation and a slew of anticipated rate hikes by the Federal Reserve. So, are bonds still a safe investment? That all comes down to how you define safety.
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Some investors view safety as the guaranteed return of principal, while others view safety as a lack of volatility. Others simply view safety as an asset that’s diversified from the rest of a portfolio. Whatever your definition of safety is, bonds may be able to provide it, even during inflationary periods. What matters is what your investment objectives and risk tolerance are, and which types of bonds you select.
Treasury Inflation-Protected Securities (TIPS)
As you might suspect simply from the name, Treasury Inflation-Protected Securities, or TIPS, are one of the best options when it comes to defending your bond portfolio against inflation. TIPS pay a fixed interest rate but adjust their principal upwards or downwards twice per year in response to changing inflation rates. As the amount of the interest payment is based on the principal value of the bond, the interest you earn can rise as well in an inflationary period.
Better still, as TIPS are U.S. Treasury securities, they are backed by the full faith and credit of the U.S. government, making them among the safest securities in the world. The downside is if the current rise in inflation only turns out to be a temporary spike, in which case your principal and resulting interest payments would adjust downwards moving forward. While the bonds would still be “safe,” they could turn into low-returning investments.
Adjustable-rate bonds, as the name implies, adjust the rate of interest they pay based on prevailing market conditions. In a time of inflation, the Fed typically raises interest rates, sometimes aggressively, in order to get consumer costs under control. While rising interest rates translate to lower prices for most bonds, the prices of adjustable-rate bonds tend to be more stable. Rising interest rates make any type of bond more appealing to investors, so as adjustable-rate bonds reset, they tend to draw investor support. In a rising-rate environment, this makes adjustable-rate bonds a safer investment. Just be sure to check the credit quality of the issuer to minimize the risk of default.
Rising rates hurt the prices of long-maturity bonds the most, as investors have to wait the longest for the return of their principal. Short-term bonds, on the other hand, can hold up relatively well, even in a sharply rising interest-rate environment. Even if you have to endure a price dip of 5% or 10%, there is little risk to owning a short-term bond because the issuer will pay you the full face value of the bond relatively quickly. U.S. Treasury bills and notes are particularly “safe” because they are backed by the full faith and credit of the U.S. government.
One of the benefits of owning short-term bonds during inflation is that when they mature, you can reinvest the proceeds into bonds paying higher rates. For example, if you buy a two-year bond paying 1%, by the time that bond matures you may be able to earn 2% or more on your new bond. You can keep repeating this pattern for as long as inflation and rising rates persist.
The Importance of Relative Performance
No investment always goes up in value, and that’s certainly true of bonds in an inflationary environment. But even if bonds go down in price, they may have value on a relative basis. Certainly, this has been true in the first few months of 2022, as many stocks are down 50% or more from their recent highs, while 30-year Treasury bonds are down just over 9%. No investor wants to lose money, and a 9% drop isn’t very soothing. But compared with the devastation that has hit certain individual stocks, and even the 12% YTD drop in the S&P 500 index, bonds have held up fairly well, even in a terrible market environment. For some investors, this type of relative outperformance is a different type of “safety” that bonds can provide.
The Bottom Line
The fact is that a rising-rate, inflationary environment is not the best time to be investing in bonds, particularly long-term bonds. But there are certain types of bonds that can hold up relatively well in this type of environment. When used as a diversification tool in an overall portfolio, bonds can still serve a purpose, even if their expected return is low.
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