Bond Alternatives if Inflation is here to stay?

[RobLJ]

For a while I've had Fidelity Floating Rate fund as about 20% of my bond allocation. 5 year return has been 3.9%; it was down about 15% at the worst of the pandemic but pretty quickly snapped back. It traditionally invests a bit more conservatively than most floating funds, so somewhat lower yield but also lower volatility.

I don't think it's a bad way to invest for higher yield particularly if you think that interest rates/inflation are going up, but I wouldn't allocate too high a percentage. I'm skeptical inflation will last much longer than a year or two, but as my grandfather always said, "We will see."
YMMV.

I haven't looked into longer term performance of floating rate funds that are comprised of the underlying instruments, but I'd have to believe that it is efficient and there aren't outsized gains to be had. I suppose it would be possible for a closed end fund/ETF to outperform simply on technical parameters. If looking to invest in floating rate instruments, that would be the way I'd do it - through a closed end fund or ETF at a point where it was relatively low.

 

[Lsbcal]

I have read through the answers here. Some good comments and some questionable ones too.

I concluded in August 2020 that bonds were OK as a holding but not to expect much. Maybe they keep up with inflation or are slightly in the looser category. So most of our bonds are in short term investment grade. If rates go up ST IG will not suffer too much and ST IG will be OK in a recession too although as things deteriorate (far in the future I hope) I might buy intermediate Treasuries. The breakdown:

40% short term investment grade (VFSUX)
28% TIPS (about 1% real return bought Oct 2018)
24% iBonds (2001 purchase, 3.4% fixed + inflation)
9% cash (includes RMD for this year)

The major action was to boost equities to the max level I can tolerate and that has paid off very well. I want to gradually reduce equities because we personally have never been so well off and as the business cycle matures I want to be in a more neutral position.

 

[Koolau]

I have read through the answers here. Some good comments and some questionable ones too.

I concluded in August 2020 that bonds were OK as a holding but not to expect much. Maybe they keep up with inflation or are slightly in the looser category. So most of our bonds are in short term investment grade. If rates go up ST IG will not suffer too much and ST IG will be OK in a recession too although as things deteriorate (far in the future I hope) I might buy intermediate Treasuries. The breakdown:

40% short term investment grade (VFSUX)
28% TIPS (about 1% real return bought Oct 2018)
24% iBonds (2001 purchase, 3.4% fixed + inflation)
9% cash (includes RMD for this year)

The major action was to boost equities to the max level I can tolerate and that has paid off very well. I want to gradually reduce equities because we personally have never been so well off and as the business cycle matures I want to be in a more neutral position.

Other than the stupid mistakes I made - back in the day (abusive tax shelters and Willie Nelson sad songs come to mind) my biggest regret is not buying $60K of I bonds a year when they first became available. I salute you!

If I could magically go back in time to 1998 and start buying I-bonds, I'd probably be something like 25% (total) I bonds at between 3 and 4% plus the inflation on that portion. (I'd have quit buying when they dropped below 3% fixed.) Since there would be no trading in or out, I'd have the other cash equivalents I still have from the era (GIF, SPDAs, etc.), PMs, which would get me to 50%. From there, I'd just add a mix of virtually every equity available, world wide. Then, I'd put my feet up and enjoy retirement - worrying only about black swans (and the boogeyman). Come to think of it, not so different than now - except I DIDN'T overweight on I-bonds. Regrets are for fools, but, every once in a while I wonder "what if?" YMMV

 

[Lsbcal]

Hi Koolau, you are not an investor if you don't have regrets. Let's see, there was Microsoft, Apple, Netflix, ... and on and on. Most of my regrets are in the equity space. Still we are doing well and enjoying life.

 

[DrRoy]

Investment grade corporate and taxable municipal bonds with 2-7 years maturity set up in a ladder is my approach.

I do the same but with about 5 more years maturity.

 

[GaryInCO]

I just don’t sweat my bond funds. Most of them I’ve held since 1999/2000 when inflation was much higher. As stocks go up I buy more. As stocks drop, which usually coincides with a drop in interest rates as well, I sell bonds to buy stocks. Rinse and repeat.

This approach, as well as the standard 80/20 or 60/40 models, rests on the assumption that equities and bonds are uncorrelated. When stocks drop, bonds rise, and vice versa.

That's usually true. It's been true for decades. BUT if inflation rears its ugly head, it may not be true any longer. Goldman Sachs says the stock/bond correlation goes POSITIVE for inflation greater than about 3-3.5%.

 

[audreyh1]

Yeah, they both go down for a while. That’s fine, I stay invested for the long term and rebalance as needed. Things come and go.

 

[Lsbcal]

Yeah, they both go down for a while. That’s fine, I stay invested for the long term and rebalance as needed. Things come and go.

I wonder about what the long term is for us. Any thoughts?

Are there special considerations at 60? What about 70? and 80? I suppose a lot of this has to do with desired lifestyles and factors beyond our control.

Example:

What if a wildfire wipes out our home and at around that time we have a bad recession or depression. These are uncorrelated events that a long time ago I would have given little concern to.

Now in California the fires are a real concern and I know people who chose not to rebuild. So you don't get fully compensated for the loss of home by the insurance company, at least not quickly.

Then suppose in the same year a 1970's economy occurs. This was bad for both stocks and bonds. Running the VPW app shows that bonds were perhaps only slightly better performers but I'm sure it depends on your actual holding choices.

I haven't even gotten into a more severe pandemic that does not find a quick medical solution. And war ... , nah not possible.

I think this is a decent argument for having a portfolio with a fair amount of stocks for growth in good times.

 

[Lsbcal]

This approach, as well as the standard 80/20 or 60/40 models, rests on the assumption that equities and bonds are uncorrelated. When stocks drop, bonds rise, and vice versa.

That's usually true. It's been true for decades. BUT if inflation rears its ugly head, it may not be true any longer. Goldman Sachs says the stock/bond correlation goes POSITIVE for inflation greater than about 3-3.5%.

The VPW app that I regularly run has shown that a 60/40 portfolio and a 40/60 portfolio were not much different for the nasty retirement year range of 1966 to 1982. In 1982 bonds and stocks both started performing well.

But people currently now running the Fed and Treasury have lived through that period. Hopefully they are well aware of the consequences of sustained periods of high inflation.

 

[audreyh1]

I wonder about what the long term is for us. Any thoughts?

Are there special considerations at 60? What about 70? and 80? I suppose a lot of this has to do with desired lifestyles and factors beyond our control.

Example:

I think this is a decent argument for having a portfolio with a fair amount of stocks for growth in good times.

Decades still.

I'm sure as we reach 70 and 80 we may well choose to dial back on the exposure to more volatile assets. Then again, maybe not.

In the meantime stocks go up and down, interest rates go up and down. I'm happy to keep rebalancing occasionally when I withdraw funds and otherwise sit on my hands.

 

[triangle]

I have not done this, but putting 2-4% of one's bond allocation into cryptocurrencies could provide a hedge. If inflation gets wild the crypto portion could potentially make up the difference in bond losses. If the crypto goes to zero, then not much has been lost. And hopefully there was some inverse correlation to other parts of the portfolio.

 

[Closet_Gamer]

Great thread...

I am of the firm belief that REAL interest rates in the US will be negative for years going forward. That and money printing will lead to a structural decline of the dollar, which will feed inflation....rinse repeat. Nothing is certain, but that is my theory.

If you're really worried about US-specific inflation driven by dollar erosion vs. the the world, a natural way to hedge this is to keep a nice chunk of money invested in international securities.

There's been many discussions on this topic and nearly all of us agree that in recent history international holdings have been laggards and even loss generators, but this is why I continue to hold a good chunk of my investments internationally.

If we talking about global inflation where the buying power of all currencies declines (which we might be due to the unbelievable number of economic forces loose in the world currently), then this wouldn't be so useful.

 

[Closet_Gamer]

Hi Koolau, you are not an investor if you don't have regrets. Let's see, there was Microsoft, Apple, Netflix, ... and on and on. Most of my regrets are in the equity space. Still we are doing well and enjoying life.

Warren Buffet said that "there are no called strikes in investing."

Its not about the ones you don't swing at.
Its about making sure the swings you do work out.

He said he believed the typical person probably needed to make 10-20 good financial decisions in their lifetime.

 

[pjigar]

He said he believed the typical person probably needed to make 10-20 good financial decisions in their lifetime.

And which security to buy is probably some of the last one one the list! For a normal working person, good financial decisions are often the simple ones: Don't buy too big of a house, Don't change cars often, don't panic when market tanks, save, etc.

 

[pb4uski]

I have not done this, but putting 2-4% of one's bond allocation into cryptocurrencies could provide a hedge. If inflation gets wild the crypto portion could potentially make up the difference in bond losses. If the crypto goes to zero, then not much has been lost. And hopefully there was some inverse correlation to other parts of the portfolio.

If we have inflation, why would crypto provide a hedge? Would the cash flows backing crypto increase with inflation? If so, why?

 

[Closet_Gamer]

That's usually true. It's been true for decades. BUT if inflation rears its ugly head, it may not be true any longer. Goldman Sachs says the stock/bond correlation goes POSITIVE for inflation greater than about 3-3.5%.

That's usually true. It's been true for decades. BUT if inflation rears its ugly head, it may not be true any longer. Goldman Sachs says the stock/bond correlation goes POSITIVE for inflation greater than about 3-3.5%.

I very much buy this theory.

For most people on this board, our investing experiences have been set against the back drop of a 30 year bull market in bonds coupled by sustained, modest inflation. Modest inflation even in the face of historically low & artificially depressed interest rates.

Let's look at the historic 10 year treasury yield in 10 year increments. These numbers are a bit cherry picked, but appear to be a decent center-point for each year.

1991 8.0%
2001 4.5%
2011 3.0%
2021 1.5%

If this flips on its head, we will likely experience something completely foriegn to most of us.

The exact ratios fluctuate, but the 10 year treasury yield and the S&P 500 yield push and pull on each other as investors balance

yield+certainty+inflation risk vs.
yield+volatility+growth potential

For example, the 10 year treasury yield is currently 1.6% and the S&P yield is 1.4%.

If you can get a 5-8% yield on Treasuries, equities should get clobbered as investors adjust to rationalize yields.

Its possible that securities as a whole could be repriced lower in a very substantial way.

 

[Closet_Gamer]

And which security to buy is probably some of the last one one the list! For a normal working person, good financial decisions are often the simple ones: Don't buy too big of a house, Don't change cars often, don't panic when market tanks, save, etc.

100%

 

[Dtail]

I very much buy this theory.

For most people on this board, our investing experiences have been set against the back drop of a 30 year bull market in bonds coupled by sustained, modest inflation. Modest inflation even in the face of historically low & artificially depressed interest rates.

Let's look at the historic 10 year treasury yield in 10 year increments. These numbers are a bit cherry picked, but appear to be a decent center-point for each year.

1991 8.0%
2001 4.5%
2011 3.0%
2021 1.5%

If this flips on its head, we will likely experience something completely foriegn to most of us.

The exact ratios fluctuate, but the 10 year treasury yield and the S&P 500 yield push and pull on each other as investors balance

yield+certainty+inflation risk vs.
yield+volatility+growth potential

For example, the 10 year treasury yield is currently 1.6% and the S&P yield is 1.4%.

If you can get a 5-8% yield on Treasuries, equities should get clobbered as investors adjust to rationalize yields.

Its possible that securities as a whole could be repriced lower in a very substantial way.

If 10 year treasuries yielded 8% again, I would think that many posters here would pile into them irrespective of what the inflation official rate is.

 

[Closet_Gamer]

If 10 year treasuries yielded 8% again, I would think that many posters here would pile into them irrespective of what the inflation official rate is.

No doubt, I would too...but the question might be "pile into them with what?"

If all asset prices get caught in the downdraft, there may not be a lot to rebalance with.

 

[Koolau]

No doubt, I would too...but the question might be "pile into them with what?"

If all asset prices get caught in the downdraft, there may not be a lot to rebalance with.

One more reason to diversify as much and as widely as possible. Almost no matter how "bad" it gets, SOMETHING is up when everything else is down. At least SOMETHING or a few things are down a lot less than other things. Diversification may be key going forward but YMMV.

 

[triangle]

If we have inflation, why would crypto provide a hedge? Would the cash flows backing crypto increase with inflation? If so, why?

The simplified thinking is that since cryptos like Bitcoin have limits to number of coins which can be printed (mined), their value tracks inflation. Though others like Dogecoin do not have limits and are not considered as serious in comparison.

Surely most have heard the explanation of how Bitcoin is like a digital gold whose numbers cannot be expanded like the Federal Reserve can do with the USD. Cyrptos have been very volatile but have continued to attract more and more attention, which has pushed up their value much faster than inflation. I suspect there are different types of buyers, from true believers to speculative buyers hoping the party continues. Although I have not been a buyer (investor) of crypto, I am of the opinion that bond returns will struggle to keep up with inflation.

Hence the comment that moving a very small percentage of one's bonds into crypto, when considering the potential for radical price expansion beyond keeping up with inflation might be a way to hedge against potential negative after inflation bond returns. A barbell strategy for the cash/bond portion of ones' portfolio.

 

[RobLJ]

I'm a simpleton, but if one is skeptical of the value of the dollar, given that one does not trust the faith and credit of the US,
what pray tell, is the "faith and credit" of bitcoin or crypto? The algorithm? (Our yewt "has" two bit coin from 3 years ago, but, alas, his hard drive crashed, so he doesn't "have it", alas. It would be a great hedge or investment, I suppose, but it's a total loss. You can dismiss this as an anomaly, but sadly, it seems pretty common. Luckily it was a while ago so it only cost him about 1k.)
I'm sorry; I just don't see the "simplified" logic of bitcoin as an inflation hedge. I suppose one could just invest in commodities and gold, although I'm skeptical of gold as an inflation hedge, other than on a 40 year cycle. That's just me, though.

 

[triangle]

....

If you can get a 5-8% yield on Treasuries, equities should get clobbered as investors adjust to rationalize yields.

Its possible that securities as a whole could be repriced lower in a very substantial way.

Is that even possible in the current environment? It has been a while since I have read anything from Peter Schiff or Marc Faber but I think they are mostly correct that it will be very difficult for Treasury yields to rise very much, as the percentage of tax revenues which will then need to be reallocated towards the national debt would be too high. Imagine the societal revolt if current programs were deeply cut to shift the tax income towards interest payments, or imagine raising taxes to the point that tax revenue dries up.

I think the best hope is trajectory we might already be on, for relatively higher asset price inflation so that the government can capture more capital gains to help stabilize the debt while interest rates are kept relatively lower in the meantime.

 

[Closet_Gamer]

Is that even possible in the current environment?

-- Pardon what I just discovered became a very long post! --


Its a fair question, though I'm sure in 1975 no would have believed we would see 20% interest rates. Times change and policies must adapt.

Can it happen?
Like in the 80s, dramatically increasing rates would require the will of both the politicians and the electorate...but high inflation can create that sort of thing.

The fed has been able to keep interest rates low against a backdrop of near zero inflation and has at times been worried about deflation. Its helped that every major country has done the same which kept the dollar pretty strong by minimizing people chasing yields in other currencies.

There has been discussion about the "war on savers", but for the most part everyone has been relaxed because a pair of jeans cost pretty much the same as the year before, employment has been solid (punctuated by the black swan implosions) and the government turned on the printing presses when things hit the fan. Its been easy for the electorate to smile and move along.

If we start seeing 4-5% inflation that could change pretty quickly. It will be tempting for the government to "inflate away the debt", but the flip side of "smile and move along" may well surface. The average Joe doesn't think about using inflation to tame federal debt. They want to know why a pair of jeans suddenly costs $75.

Inflation hit 14% in 1980. We all know what followed.

So...what are the risks of high inflation?

I have no idea...but a few things I think about:

1) We are experiencing multiple global supply shocks simultaneously. In my industry, we're having to make consumer equipment procurement decisions 60 weeks out due to the shortage of chips. 60 weeks. It used to be 10 weeks.

2) Inflation has partially been held back over the last 30 years by the surge of globally cheap labor and accomodative trade policies. China is aging rapidly and lots of other countries lack the maturity to step into the demand.

3) Driven by geo & domestic political considerations and witnessing the global supply chain problems, western countries & big corporations are having serious conversations about "re-shoring" major industries into higher cost of labor/cost of operation countries. Aggressive climate policies may increase the costs of re-shored operations.

4) There is a shocking amount of cash sitting on the sidelines from the tale of two pandemics. For the white collar world, they stopped spending but kept earning. For the less fortunate, they got checks. Lots of people got both.

Its party time and many people have the cash to spend into the inflation. DD wants and iPad for university this fall. She'll get one even if its $50 more because I've loads of cash from not being able to travel last year. The guy after me might pay $50.01 more...$50.02...$50.03...lots of people want ipads.

If those forces combine?
Yes, we could see substantive inflation.

Will the Fed step in and use interest rates to curtail it?
Quite possibly.

So, yes, I think it could happen.

 

[Koolau]

I have not done this, but putting 2-4% of one's bond allocation into cryptocurrencies could provide a hedge. If inflation gets wild the crypto portion could potentially make up the difference in bond losses. If the crypto goes to zero, then not much has been lost. And hopefully there was some inverse correlation to other parts of the portfolio.

No idea if you are correct or not. But why not consider something "real" like PMs? They never go to zero. They don't get lost in the "ether." People instinctively understand them (not the subtleties perhaps) since they've been valued since antiquity. Even if gummints hate them, it's difficult to take them away except at the point of a gun. They have a track record - spotty though it is. You can hold them in your hand.

Given that they are a "bad" investment in most good times - which is why you don't keep a lot of them. 2-4% sounds about right. Very much a YMMV investment.