How to protect your fixed-income investments from inflation

  • While a strong economy and low unemployment are overall good news, they also tend to augur inflation.
  • Try not to panic. Stick to your long-term plan.
  • Diversify within your fixed-income investments, and look at your portfolio holistically.

Fixed-income investments typically offer a safe haven for investors who want reliable returns and some protection from the volatility of the stock market.

The downside of fixed-income investments, however, is that over time inflation can significantly drag down your real returns.

"Inflation and fixed income are not a good combination usually," said George Rusnak, co-head of global fixed-income strategy at Wells Fargo. "Inflation eats away at your returns, and if your return is fixed in nature, it erodes quickly."

Inflation
Colin Anderson | Getty Images

This hasn't been much of an issue in recent years, when the biggest concerns about inflation have been that it was too low.

At a consumer level, inflation has been below 3 percent for the past 20 years, and it's been less than 2 percent for eight of the 10 years since the Great Recession. It has been trending up lately, increasing steadily to 2.9 percent for the 12 months ended July 2018, from 1.9 percent last August.

The Federal Reserve indicated at its August meeting that it would likely raise interest rates in September and once more after that by the end of the year. While a strong economy and low unemployment are overall good news, they also tend to augur inflation.

If that has you worried about your fixed-income investments, here's what to do.

1. Don't panic. Inflation is a factor that all investors should account for in their investment decisions. But like any other market forces, changes to your portfolio should be made with rational thought and in adherence to your long-term plan, rather than in reaction to real-time changes.

"Just as you can't time the stock market, you can't time inflation or interest rates," said Justin Fort, founder and president of Fort Wealth Management. "Those are unknown factors moving forward."

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The current inflation rate is still relatively low, and most economists don't expect a huge spike this year. The one wild card is a prolonged trade war, since tariffs can significantly push up costs for consumers and cause a spike in inflation.

2. Diversify within your fixed-income investments. Fixed-income investments as a whole are extremely sensitive to inflation, but there are some categories of fixed-income investments that offer more shelter from inflation than others.

"We like to diversify into a lot of different fixed-income instruments," said Brett Ewing, chief market strategist with First Franklin. "If your entire fixed-income portfolio is in Treasurys, that's not going to protect you."

Shortening the duration of bonds and bond funds, for example, is one way to buffer yourself from the impact of rising rates. That's because shorter term bonds allow you to lock in current rates now but repurchase new investments at potentially higher rates when the shorter-term ones reach maturity.

Other investments include floating-rate notes, high-yield corporate bonds and some REITs, all of which tend to perform well in a rising rate environment and a strong economy. A recent analysis by Morningstar found that U.S. credit performed the best relative to inflation, followed by Treasury Inflation-Protected Securities [TIPS], mortgages, and nominal Treasurys.

TIPS pay out a guaranteed return adjusted for inflation, but the return on TIPS tends to be lower than what you can get from other types of investments. Plus, they're sensitive to interest rates, and you could lose money if you're buying individual TIPS and need to sell before maturity.

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"Because they're bonds and the interest rate has been rising, the principal return [on TIPS] is negative," said Gemma Wright-Casparius, a senior portfolio manager of the TIPS funds at Vanguard. "But because inflation is positive, that positive inflation is helping offset the negative returns."

Wright-Casparius says even a small allocation to TIPS can serve as a hedge against inflation, but that retirees might consider allocating a larger portion to TIPS. The Vanguard target-date fund glide path slowly increases retirees' TIPS investment to more than 10 percent.

3. Look at your portfolio holistically. For investors with a longer time horizon, fixed-income may not provide the ultimate returns necessary to keep pace with inflation over the long term. Balancing out your fixed-income investments with equities can make for a more diverse, growth-oriented portfolio.

"People tend to flock to investment that they think are safe," said Steve Burnett, president of Hanson McClain Investment advisors. "If people over the past several years, since the collapse, flocked to safety and built a large portion of their portfolio in fixed income, they've had a big run as interest rates came down.

"But now they need to consider a more balanced portfolio," he added. "An all-income portfolio could really struggle in coming years."

— By Beth Braverman, special to CNBC.com

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