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Bonds are not usually the first asset class experienced investors focus on when it comes to inflation. But even during times of rising price levels, there’s a need to make sure that at least some of your portfolio is held in relatively safe assets.
Bonds qualify as safe assets because they pay a fixed rate of interest, and payment of principal is generally guaranteed if the securities are held until maturity. How exactly do bonds fit into your portfolio when dealing with inflation?
7 Best Bond Funds For Inflation In 2022
Fortunately, there’s an entire class of bonds that are designed specifically to provide protection against inflation. Holding at least some of these bonds in your portfolio can both protect your holdings from inflation while providing a higher level of security that you can get with a portfolio comprised entirely of equities, or even other bonds.
Why Bonds are not Usually Good Inflation Investments
What makes bonds a risky bet during times of inflation is rising interest rates. Those rates are at least loosely correlated to inflation. As the rate of inflation increases, investors naturally demand a higher return on bonds to compensate for higher price levels.
But since bond price levels have an inverse relationship with interest rates, rising inflation – and the higher interest rates it causes – can make bond prices fall.
For example, let’s say you’re holding a 20-year bond currently paying 3%. If inflation causes prevailing interest rates on 20-year securities to rise to 4%, the market value of your bond will decline until the interest yield is more consistent with prevailing rates. (You’ll still receive the full principal value of your bond upon maturity, but you could suffer a capital loss if you sell it in the rising rate environment.)
Interest rate risk is greater on longer-term bonds, particularly those with maturities of 20 years or more. Bonds with remaining maturities of one or two years may see little if any decline in principal value.
This inverse relationship makes bonds a losing asset class in the face of rising inflation. But as I said earlier, there is one exception to the rule.
Best Bond Funds For Inflation: What are TIPS Bonds?
Treasury Inflation Protecte Securities, commonly abbreviate as simply TIPS, are U.S. Treasury securities designe specifically to compensate investors for inflation.
Though the bonds will carry a fixe interest rate, the principal value of the securities will increase with inflation. The Investment opposite is also true – the value will decrease in a deflationary environment. However, the securities will pay full face value if they are held to maturity, even in a deflationary market. You’re guarantee to receive the greater of the adjuste principal value or the original value of the security.
TIPS are issue by the Treasury in denominations $100. Terms come in three tiers, five, 10 and 30 years. Interest on the securities is paid every six months.
While the interest and principal increases are subject to federal income tax, both are exempt from state and local income tax. This gives them at least a slight tax benefit, especially in high tax states.
And since TIPS are issue by the Unite States Treasury Department, they have the highest safety rating possible.
Best Bond Funds For Inflation: How do TIPS Bonds Protect Against Inflation?
The secret sauce that protects TIPS from inflation is the principal adjustments adde to the security value in response to inflation. The adjustments are base on the TIPS Inflation Index Ratios, which is base on the Consumer Price Index, provide by the Bureau of Labor Statistics.
However, you should be aware that since TIPS offer inflation protection through principal adjustments, the interest rates they carry are lower than U.S. Treasury securities with similar terms.
For example, while the 10-year Treasury note currently pays 1.31%, the yield on the 10-year TIPS note issue on July 15, 2021, is just 0.125%. But the 10-year TIPS note already has an index ratio 1.02062 as of October 31, 2021. That means a little over 2% will be adde to the principal value of the security just a little over three months after it was issue.
In that way, the principal adde – plus the interest, low that it is – provides a higher combine return than what you can get on the non-TIPS 10-year Treasury note.
If inflation continues to rise, the principal adjustment on the TIPS security will also increase. That’s why TIPS are the exception to the general bond rule when it comes to inflation. They provide guarantee principal, protecte from inflation, with a steady income stream, and even exemption from state and local income tax.
You can invest in TIPS directly through the U.S. Treasury’s investment portal, Treasury Direct. There, you can buy, hold, and even sell your securities.
But if you’d rather invest in a portfolio of TIPS securities, there are many bond funds that specialize in this asset class. They can provide a mix of interest rates and maturity dates, and even enable you to target specific maturity ranges, like five years or less, or 10 years or more.
What’s more, while TIPS themselves pay interest only twice each year, a TIPS fund may be set up to pay interest on a monthly basis. Here is the list of what we believe to be the best bond funds for inflation in 2022:
Schwab US TIPS ETF (SCHP)
We are putting the Schwab US TIPS ETF (SCHP) at the top of the list because it’s one of the most common TIPS ETFs use by robo-advisors. That speaks volume about the reliability and performance of the fund. It’s also the largest single TIPS ETF on this list, with nearly $20 billion in assets under management.
The fund’s goal is to closely track the performance of the Bloomberg US Treasury Inflation-Linke Bond Index (Series-L), which invests in the overall maturity spectrum of the entire U.S. TIPS market. It’s worth noting this fund has one of the lowest expense ratios in the industry, at just 0.05%.
- One-year Performance: 5.67%
- Expense Ratio: 0.05%
- Annual Dividend Yield: 3.01%
- Total Number of Holdings: 45
- Assets Under Management: $19,735 billion
- Number of Shares Outstanding: 313,100,000
- Fund Inception: Aug. 5, 2010
- Recent NAV: $63.03
- Index: Bloomberg US Treasury Inflation-Linke Bond Index (Series-L)
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SPDR FTSE International Government Inflation-Protecte Bond ETF (WIP)
SPDR FTSE International Government Inflation-Protecte Bond ETF (WIP) is an excellent choice if you’re looking for a TIPS equivalent with international diversification. Offere by State Street Global Advisors, the SPDR FTSE International Government Inflation-Protecte Bond ETF seeks to provide investment results that match the price and yield performance of FTSE International Inflation-Linke Securities Select Index.
That index is designe to measure the total return performance of inflation-linke bonds outside the Unite States, but similar in that they offer fixe-rate coupon payments that are linke to an inflation index.
The fund includes TIPS equivalents issue by the governments of develope and emerging nations. The main purpose is to hedge against the erosion of purchasing power due to inflation outside of the U.S.
The fund includes government debt TIPS equivalents from Canada, Mexico, Australia, Turkey, South Africa, Brazil, Japan, Israel, Columbia South Africa, Chile and multiple European countries, and is rebalance on the last business day of each month.
Unlike US-base TIPS funds, in which all bonds held are rate AAA, only 20.32% of the bonds in this fund are rate AAA. Though most of the rest are considere investment grade, more than 30% are either rate below BAA (21.62%) or not rate at all (9.09%).
Given that it is an international bond fund, the yield is heavily impacte by both a high expense ratio (0.50%) and foreign taxes impose on distributions. It’s also a relatively small fund, with just 8 million shares outstanding.
- One-year Performance: 6.06% (but 4.76% after taxes on distributions)
- Expense Ratio: 0.50%
- Annual Dividend Yield: 3.09%
- Total Number of Holdings: 211
- Assets Under Management: $449.39 million
- Number of Shares Outstanding: 8 million
- Fund Inception: March 13, 2008
- Recent NAV: $56.17
- Index: FTSE International Inflation-Linkd Securities Select Index
The FlexShares iBoxx 5-Year Target Duration TIPS Index Fund (TDTF) targets a specific niche in the TIPS bond market. That target is TIPS with maturities approximating five years. However, the fund will hold TIPS with maturities ranging from as little as three years to as many as 20. But the average will be maintaine at approximately 5 years. It’s rebalance on a monthly basis.