When evaluating each inflation-fighting strategy in light of your client’s goals, consider three questions: How consistently does the solution hedge inflation? How sensitive is it to inflation? And how cost-effective is it?
How to Protect Your Clients from Inflation
5 min read
Key Takeaways
- Higher inflation poses real risks to clients’ portfolios, eroding investment returns and purchasing power. This has spurred interest in inflation protection.
- There are a variety of actively managed investing approaches for helping clients’ portfolios navigate a higher-inflation world, some implicit and some explicit, including inflation-protected bond funds.
- Credit exposure may be able to “outyield” inflation, while Treasury Inflation-Protected Securities (TIPS) offer explicit inflation protection. A multi-sector bond approach that integrates TIPS exposure may offer a compelling solution.
- Combining conventional municipal bonds with inflation swaps offers explicit inflation protection along with tax advantages from both municipal bond income and potential gains on swap instruments.
How is inflation affecting my clients?
Inflation, in the background for decades, has come roaring back in the aftermath of the global pandemic. Knots in the global supply chain and the war in Ukraine have pushed up prices overall—particularly energy costs. By mid-2022, the Federal Reserve had made tackling inflation its number-one job, with a series of sharp interest-rate hikes that rattled investors and threatened to further sap economic growth—the engine of financial growth.
With inflation surging to levels not seen since the early 1980s, risks from rising prices have moved front and center in many investors’ minds. So has the need to respond by seeking inflation-protected mutual funds.
Inflation hurts investors in two ways. First, it eats away at the nominal returns of investments across asset classes. For example, let’s say that a well-diversified investment portfolio generates an annualized return of 6%. If inflation is even at a moderate level—2.5% annualized—the inflation-adjusted, or real, return of that portfolio is only 3.5%. Investments must work that much harder against the rising cost of inflation.
Second, for income investors, the pain can be felt in the lower real value of the income generated by their investments—typically bonds. Clients who rely on investment income will find that the income their bond portfolios generate doesn’t necessarily go as far as it used to. That’s because those dollars are being spent on increasingly costly goods and services. Businesses feel the pinch of higher expenses, too; if they’re unable to pass those costs on to customers, their profitability takes a hit.
While we don’t expect lofty inflation rates to last, even a moderate level of inflation can inflict a substantial amount of pain. It’s no surprise, then, that clients are looking for diverse approaches to shoring up their investment returns and income against inflation’s bite, including identifying stocks from companies that can maintain pricing power, real asset strategies, inflation-protected bond funds and inflation-protected municipal bond funds.
How do I protect my clients from inflation with mutual funds?
Fortunately, a number of solutions can help cushion your clients’ portfolios against the impact of rising inflation—some implicit and others explicit, including inflation-protected bond funds and inflation-protected municipal bond funds.
One implicit approach to tackling inflation comes from the equity side. In our view, certain companies are better equipped to navigate higher-inflation environments, because they’re more able to pass rising costs through to customers via higher prices. The ability to identify these companies—and to apply active research and engagement to pin down companies with quality businesses—can help investors stay diversified across individual issuers while maintaining broad exposure to equity market returns.
Another implicit approach to battling inflation is using bond allocations that may be able to “outyield” inflation. Rising prices erode the power of income over time, so a thoughtfully designed exposure to high-income segments of the fixed-income markets may provide a larger yield cushion. Given the sharp increase in yields during 2022, those yields are now much more attractive; US high-yield bonds are a case in point. It’s also possible to combine a diverse array of income segments, including emerging-market debt and even bank loans, to generate efficient income that capitalizes on higher yields.
In addition to implicit inflation-fighting approaches, there are explicit inflation-protection solutions. For example, real assets such as commodities, real estate, inflation-sensitive equities and commodity futures have historically been effective to varying degrees in cushioning against rising price levels. Because no single real asset wins all the time, we think a diversified mix of real assets can be an efficient approach.
The fixed-income world also offers explicit inflation-protected strategies—notably inflation-protected bond funds and inflation-protected municipal bond funds, which can bolster an overall portfolio against the pain of rising price levels.
How do I protect my clients from inflation with taxable bond funds?
One way to seek implicit inflation resilience through fixed-income strategies is by “outyielding” inflation. Since rising prices chip away at portfolio yield, bumping up that yield through exposure to higher-yielding credit sectors can increase the cushion. Because the return patterns of income-generating bond sectors fluctuate over time, leadership among sectors tends to change hands. That’s why we believe that a diversified, efficient income approach can be an effective way to bolster yield in the face of inflation.
From the perspective of explicit inflation protection in the taxable bond world, Treasury Inflation-Protected Securities (TIPS) can play a role. They protect in two ways: First, the principal value of TIPS is indexed to inflation, so when inflation rises, so does the value of TIPS. Second, TIPS’ coupon payments are inflation-adjusted: payments are based on the inflation-adjusted principal value of the TIPS multiplied by the coupon rate.
Historically, TIPS have outpaced US Treasuries when inflation is above normal and rising, which could make them a sensible replacement for traditional Treasury exposure. But because TIPS yields are generally low, investors will need more yield to benefit from an inflation-protected bond fund. One solution would be to replace the Treasury allocation within a multi-sector bond strategy with TIPS exposure. Because it taps into diverse market segments with more attractive yields, the multi-sector component can give an inflation-protected strategy a more compelling risk/return profile.
How do I protect my clients from inflation with municipal bond funds?
For investors subject to individual income taxes, municipal bonds have been a longtime staple. The income they pay is exempt from federal taxes and often from state taxes, depending on a client’s specific situation. As with TIPS in the taxable bond market, municipal inflation-linked debt is designed to provide a measure of inflation protection. The face amount and interest payments are adjusted based on inflation.
One challenge: municipal inflation-linked debt is only sparsely available. For one thing, the market is a relatively small one—just over $1 billion. It’s also not very liquid, making it a challenging arena for investors to navigate. Because of these drawbacks, inflation-linked municipal bonds often trade at higher prices relative to TIPS than is indicated by the typical relationship between municipal and Treasury yields.