Surging Inflation and Volatile Bond Prices Are Challenging Investors

Investors seeking to steer clear of the twin hazards of rising inflation and falling bond prices might feel as if they’re being asked to navigate between the mythological sea creatures Scylla and Charybdis.

On the one hand, global inflation, driven in large part by higher food and energy prices, has spiked to levels unseen in a generation. Anyone who has recently strolled the aisles of a grocery store or filled up their car’s gas tank has felt the pinch. On the other hand, the Federal Reserve has indicated that it might try to put a damper on inflation by tapering its bond purchases and raising the interest rates under its control. Those moves could reduce the value of existing bonds.

Nevertheless, some bond investors say it is already time for the Fed to act. “We’re starting to get to a point where they should have done it already,” said Rob Daly, the director of fixed income at Glenmede Investment Management, a money management company based in Philadelphia.

The U.S. Consumer Price Index, which includes volatile food and energy prices, rose 5.3 percent over the 12 months that ended in August, the most recent data available. Federal Reserve officials attribute this surge to the rapid reopening of the economy and supply chain issues caused by the global pandemic, a situation that they say should be “transitory.”

Even without pre-emptive Fed action, spiking inflation could itself drive the yields on new bonds higher, because investors expect at least some real return, above the inflation rate. But because yields and prices move in opposite directions, rising yields would make the prices of existing bonds fall.

Dealing with the twin threats of inflation and vulnerable bond prices is challenging, but it’s worth remembering that even in a bad year, high-quality diversified bond portfolios tend to be far steadier than stocks. Still, the current volatile environment for bonds may be worrisome.

John Maloney, the chairman and chief executive of M&R Capital Management, a New York money management firm, has been safeguarding the value of his investors’ fixed-income portfolios by shifting them into ultrashort bond funds, with average durations of less than a year. Duration is a measure of a bond’s price sensitivity to changes in interest rate, or yield; the shorter the duration, the less a bond’s price will be affected.

One fund favored by Mr. Maloney is the JP Morgan Ultra-Short Income Exchange-Traded Fund , which has yielded 0.78 percent over the last 12 months after a management fee of 0.18 percent. Another is the PIMCO Enhanced Short Maturity Active E.T.F. , which has yielded 0.48 percent after a management fee of 0.36 percent.

The value of such funds does fluctuate somewhat, so they may not be suitable for investors with an immediate need to convert them into cash. Still, he said, they are “a place to get a bit better return on your money than a money-market fund, which is paying virtually zero at this point.”

Investors willing to stretch the duration of their bond portfolio a bit further might consider the Vanguard Short-term Corporate Bond Index Fund. Both the E.T.F.and mutual fundversions of the fund have yielded around 1.7 percent over the last 12 months and have an average duration of three years.

For those already willing to take the risk of holding high-yield bonds — also known as junk bonds because of their relatively low credit quality — Kathy Jones, the chief fixed income strategist at the Schwab Center for Financial Research, suggested shifting some of those holdings to bank loan funds. As the name implies, such funds invest in loans made by banks and other financial institutions to corporations. They tend to have a shorter portfolio duration — often measured in just a few months — than high-yield bond funds. But in a downturn, they can be risky.

So, for example, during panic selling from Feb. 20 to March 23, 2020, early in the pandemic, the S&P 500 plummeted 34 percent, and bank loan funds and high-yield bond funds both fell on average 20 percent, according to Morningstar Direct. By comparison, short-term bond funds lost, on average, less than 5 percent of their value.

Bank loan funds have fared better as investors hunted for yield over the past year. The T. Rowe Price Floating Rate Fund had a total return of 7.16 percent for the 12 months ending on Sept. 30 and a trailing 12-month yield of 3.93 percent, according to Morningstar Direct. The managers of that fund typically put 80 to 90 percent of the portfolio into bank loans. The fund’s expense ratio is 0.76 percent.

Although shortening the duration of a bond portfolio might mitigate the shocks of interest rate increases, it doesn’t directly address the problem of persistent inflation.

“I would not be a good bond manager if I did not say that inflation is a concern,” said Adrian Helfert, the chief investment officer of multi-asset strategies at Westwood Management, an investment management company based in Dallas. “It does erode the future value of an investor’s portfolio.”

A well-worn anti-inflationary tool in the bond investor’s kit is Treasury Inflation Protected Securities, better known as TIPS. The principal of these government-issued securities adjusts with inflation.

The PIMCO Real Return Fund, with holdings primarily in inflation-protected securities, had a total return of 5.15 percent over the 12 months through September, after a management fee of 0.87 percent. The duration of the portfolio is nearly eight years.

As concerns about inflation grew over the last year, investors bid up the prices of TIPS and by now, many experts say, it is becoming harder to recommend these securities. The market is pricing in 2.5 percent average annual inflation over the next five years. If inflation rates come in above that, then owning TIPS would be more profitable than comparable Treasuries. But if inflation is lower than that, investors who own plain vanilla Treasuries would fare better.

There is no simple solution, unfortunately.

“What is underappreciated by markets is that it’s difficult to fight the central banks,” Mr. Helfert said. “If the Fed says inflation will be transitory, they can make it transitory by pulling the punch bowl from the party.”