Bond investors feel the heat: adding inflation fighters to portfolios

Sep 23, 2021
  • Karen Schenone, CFA

While the U.S. embarks on its recovery from the COVID-19 pandemic, bond investors have grown concerned with the spike in inflation. The investing world was abuzz with the news that the Consumer Price Index (CPI) rose 5.4% year-over-year, which is the largest jump since September 1990. The biggest risk for investors is that inflation can erode the purchasing power of savings. If the returns of your bonds are less than the realized inflation rate, then a return that appears positive on paper may actually be negative in real terms. Unlike prior interest rate cycles, bond yields have not risen with inflation as the U.S. Federal Reserve has kept interest rates low to allow the economy time to recover.

Bond yields not keeping up
CPI year-over-year vs. bond sector yield-to-worst

This is yield chart image

Source: Bloomberg, U.S. Bureau of Economic Analysis, FDIC, as of 6/30/21. Fixed income asset classes represented by their respective Bloomberg indices.

So why is inflation running hot?

Recent changes in the following factors has contributed to rising inflation:

  1. Monetary policy

The Federal Reserve’s new “Flexible Average Inflation Targeting” framework may allow for periods where inflation exceeds the 2% target.

  1. Fiscal boost

Stimulus packages should aid economic recovery but may have inflationary impacts in the long run.

  1. Release of pent-up demand

Spending surges following re-openings may put upward pressure on prices.

  1. Supply chain disruption

The effects of shortages and rising production costs may be passed on to consumers

Picking the right inflation protection for your bond portfolio

Investors can build potential inflation fighters into bond portfolios that may directly or indirectly help counteract the impact of inflation. Here are four ideas that can mitigate the impact of inflation on bond portfolios. 

  1. Treasury Inflation Protection Securities (TIPS)

TIPS are government bonds with principal values that adjust with changes in the CPI. Changes in inflation are passed through via monthly income distributions, so as inflation ticks up, the ETFs are designed to pay out more income.

iShares TIPS Bond ETF (TIP)

iShares 0-5 Year TIPS Bond ETF (STIP)

  1. iShares Inflation Hedged Corporate Bond ETF (LQDI)

LQDI provides exposure to investment grade corporate bonds and seeks to mitigate inflation risk with inflation swaps. LQDI may earn an additional return over corporate bonds when inflation is higher than expected.

iShares Inflation Hedged Corporate Bond ETF (LQDI)

  1. iShares Fallen Angels USD Bond ETF (FALN)

FALN invests in high yield corporate bonds that were originally rated investment grade. FALN has historically held higher exposure to cyclical sectors, such as energy, compared to the broad high yield market. 

iShares Fallen Angels USD Bond ETF (FALN)

  1. iShares Convertible Bond ETF (ICVT)

ICVT provides exposure to convertible bonds, which can convert to issuer’s common stock. In rising rate environments, stocks tend to outperform bonds. Since a convertible bond’s price is influenced by the value of its underlying equities, its price is generally less influenced by changes in interest rates than other fixed income securities.

iShares Convertible Bond ETF (ICVT)

Portfolio construction example: inflation-protected core bonds

Investors might be asking themselves how much inflation protection to add into their bond portfolios. Bond ETFs offer a low-cost way for investors to fine-tune portfolios with broad or targeted bond exposures. In the example below, we’ve swapped out parts of the Bloomberg U.S. Aggregate Bond Index with inflation fighting bond ETFs in an effort to create an inflation-protected core exposure. Specifically, we’ve replaced the treasury and corporate bond exposures with TIPS (TIP, STIP) and inflation-hedged corporates (LQDI). The resulting hypothetical portfolio has over 60% allocated to inflation-focused strategies but would maintain similar yield and duration characteristics to the index.

This is inflation focused portfolio image

Source: Bloomberg, BlackRock, as of 6/30/21. ETF yields are yield to worst. The weighting of the Bloomberg U.S. Aggregate Bond Index is as follows: treasuries accounts for 37.8%, corporates accounts for 26.5%, MBS accounts for 27.3%, agency accounts for 6% and CMBS accounts for 2.4%. The weighting of the Inflation Focused Portfolio is as follows: TIP/STIP blend accounts for 37.8% where 32.9% is TIP and 4.9% is STIP, LQDI accounts for 26.5%, MBB accounts for 27.3%, AGZ accounts for 6% and CMBS accounts for 2.4%. The performance quoted represents past performance and does not guarantee future results. Investment return and principal value of an investment will fluctuate so that an investor’s shares, when sold or redeemed, may be worth more or less than the original cost. Current performance may be lower or higher than the performance quoted. Performance data current to the most recent month end and standardized performance may be obtained by clicking here. Index performance is for illustrative purposes only. Index performance does not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. This information should not be relied upon as research, investment advice or a recommendation regarding the Funds or any security in particular. This information is strictly for illustrative and educational purposes and is subject to change. This information does not represent the actual current, past or future holdings or portfolio of any BlackRock client.

Investors can prepare their portfolios for this stop-and-start recovery by making adjustments that aim to protect against inflation over the long-term. Bond ETFs can be used to customize investment portfolios, including combatting the impact of inflation, and they are a low cost, tax efficient way to navigate today’s bond markets.