The month of October has traditionally provided a scare to more than just trick-or-treaters. From double-digit inflation to record-setting stock market declines, historically October has offered plenty for grown-up investors to fear as well. After years of relative calm, now is a good time to remember what can happen, and how you can prepare to weather the next storm.
When Inflation Comes Knocking
October 1981 marked the last month in modern history that the U.S. saw double-digit inflation. Inflation had been running at 12% or higher since 1979, and 10-year Treasury notes were yielding over 15%. Although this was an extreme point in history, even modest inflation can prove to be one of the worst long-term enemies for a retiree. Even with just 3% inflation, the purchasing power of your savings declines 45% over 20 years. For a retiree with fixed-income investments, this can present a huge problem.
Now, after years of low interest rates and an “easy money” Federal Reserve policy, many fear that inflation could be on the horizon. At a time when investors are getting sub-3% interest rates on 30-year Treasury bonds, an uptick in inflation could very quickly turn that investment into a depreciating asset.
So what options do you have to protect your fixed-income portfolio from a future rise in inflation?
The first option is TIPS, or Treasury Inflation Protected Securities. These are U.S. Treasury bonds whose value adjusts to changes in the Consumer Price Index (CPI). If inflation rises, the value of your TIPS bonds will also rise, providing you with increased interest payments to help offset rising expenses.
Another option is I Bonds, which are a form of savings bonds offered by the Treasury where interest is paid in two parts. There is a fixed rate, set when the bond is issued, and a variable interest rate based on the CPI. Every six months the variable-rate portion of the bond’s interest payment is adjusted to the current inflation level.
Both of these options will help protect your Treasury investments from the damages of inflation, as measured by the CPI.
For savers who want to use traditional bonds or CDs, there are other options.
One simple strategy is to invest in shorter-maturity bonds to prevent your savings from being trapped in a low-yielding investment. Investing in shorter-maturity bonds and CDs will allow you to reinvest your savings sooner, at a higher interest rate if rates continue to climb. You can accomplish this by constructing a bond ladder, or buying bonds of a specific maturity. If you buy a 10-year Treasury note today, you will earn around 2.3% for the next 10 years. By investing in a two-year note you will get a little lower interest rate, around 1.55% per year, but you will have the option to reinvest that money into a higher-yielding investment much sooner if inflation begins to pick up.
If history is any lesson, now is an opportune time to pick shorter-maturity investments over their longer-term counterparts. The spread, or the difference, between the interest rates on a two-year and 10-year Treasury note is near a 10-year low. As I write this (in mid-October 2017), there is a 0.76% spread between their interest rates, the lowest since 2007 (when the spread turned negative).
This means that savers are penalized much less by selecting shorter-term fixed-income investments, effectively giving them a cheaper form of “inflation insurance.”
Of course, these options have potential drawbacks as well. TIPS will have a lower total return if inflation remains subdued, and short-term Treasuries will return less than long-term Treasuries if interest rates stop rising. Like in all aspects of investing, diversification is important. By allocating at least a portion of your fixed-income investments in a way that protects against rising inflation, you can significantly reduce your portfolio’s risk to inflation’s damage.
Matt is the founder of Hylland Capital Management (opens in new tab), a fee-only, virtually based financial planning and investment advisory firm designed for today's young professionals. Matt is a member of the XY Planning Network.
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