How Do Bonds and Other Investments Protect Against Inflation?

Inflationary data continues to run much hotter than the Federal Reserve has expected.  This inflationary pressure is delaying, if not outright halting the Fed’s plans to reduce interest rates this year.  This is a very negative development given financial markets, had been rallying since October in the hopes of a rate -cutting cycle.  We always encourage clients to ask questions that we can address in our newsletters, so this article is a response to a question pertaining to how inflation impacts our investments, particularly our bond investments.

With the way most governments run massive budget deficits and print money, inflation is nearly a constant force, almost like gravity.  As prices rise, our money declines in value.  Money sitting in a low-interest bank account is like a closet full of designer clothes, that is infested with mice and moths.  The value declines further the longer it is exposed.  To protect against inflation, one must convert cash into appreciating assets.  Traditionally, stocks, real estate, and commodities such as oil and gold have been some of the best hedges against inflation.  

Gold has been a great hedge against inflation because it has been valued by most cultures across thousands of years due to its qualities such as its appearance, its durability, and its utilization as a storage of value.  A husband giving their wife a golden bracelet because they messed up is a story dating back to at least the Egyptians, and more likely much further than that.  Oil is another example of a product that has so many uses, that it has kept up quite well with inflation.  When prices decline, production drops, ultimately evening out the supply/demand dynamics.  

Stocks are simply fractional shares of businesses.  Many businesses have pricing power, as we see each day as we pay our rapidly rising insurance, grocery, and other bills.  They can be a good hedge against inflation because it allows you as the investor to participate in the price increases, and not to just fall victim to them like the poor soul keeping all their hard-earned capital in that low interest bank account.  With that said, stocks aren’t always a good hedge against inflation.  When stocks are overvalued, they are often prone to large declines, which can last many years.  A lost decade for stock returns is not really an uncommon occurrence across markets.  Another thing that can happen is that someone could invest in stocks to hedge against inflation, but then as the Fed hikes rates to confront the inflation, the economy tanks into a recession, taking the stock market with it.  In this circumstance, you still had to pay the elevated prices that come with inflation, but now your investment portfolio might be down 30% from where it was.  This is why we want to be very careful with general statements such as stocks are a good hedge against inflation.  That statement might be true over 50 years, but I wouldn’t want to make that bet necessarily for the next 5-10 years.  In general, I believe equity markets are expensive, although there are indeed pockets of value. Dividends are a great way to help offset inflation, especially when we can get stable and growing yields in excess of the inflation rate, which defines nearly all the stocks we have been buying.

Real estate is another asset class that does a good job for the most part keeping up with inflation.  Valuable real estate can produce cash flows for many decades, and it doesn’t always require the massive and constant capital investments that other assets, such as a manufacturing company might require.  Usually, leases have rent escalators with either a set rate, or adjusted to CPI.  This provides a natural hedge to inflation.  With that said, just like with stocks, valuations matter.  Residential real estate has not declined much in value despite the rapid ascension of interest rates, but commercial real estate has seen declines varying from 15-50%, and even more for the challenged Office sector.  This has set the stage for very attractive opportunities to buy publicly traded real estate companies with the best management teams in the world, offering dividends between 5-8%, and 50-75% upside on the stocks over the next 3–5-year period.  These companies are seeing their rents rise but are feeling the pressure from their financing costs increasing when they refinance debt.  Given that those cash flows will last decades, there is major upside potential when we do see rates go down, and that headwind starts to abate.

This brings us to bonds.  Bonds can be good investments in an inflationary environment, or they can be bad investments.  Once again, this is where valuations matter.  T&T Capital Management was not the firm stuffing bonds into client accounts to build the cookie-cutter portfolios based mostly on age, which has become so common across the industry.  We consistently called out the fact that there was over $15 trillion dollars invested in negative-yielding bonds.  Imagine the pension plans, 401k funds, and index funds, which were buying that garbage.  Instead of buying bonds when rates were about as enticing as a colonoscopy, we utilized innovative strategies such as covered calls and cash-secured puts to generate income and reduce risk.  However, the calculus changed over the last 12-18 months, after the Federal Reserve engaged in one of its steepest rate-hiking cycles in history.  We have been able to buy investment grade bonds at yields between 6.5-8%.  At the peak of the so-called banking “crisis” last year, we were getting over 10% on some investment grade bonds.  These are very attractive returns, far in excess of inflation. There is further upside if rates do drop from here, so there is the potential to earn mid-teen type returns as we saw last year when rates dropped towards the end of the year.

In addition to only buying bonds when the valuation makes sense, we also protect our clients via creating bond ladders.  Short-term bonds are the best bond protection against rising rates, because they adjust along with rates.  The risk with them is generally reinvestment risk, as if rates go down, you are not going to be able to get the same yields you were getting.  Conversely, long-term bonds go down in price when rates increase, but they also go up in price when rates go down.  We build portfolios with short, intermediate, and long-term bonds.  REITs work in a similar way as long-term bonds to some extent because the cash flows are longer duration, which is why we often supplement them with shorter-term loans and bonds, often with adjustable rates.

The message here is that rules of thumb are helpful introductory guides into investing, but they are not enough.  Investing is the practice of buying securities at a discount to intrinsic value, with the expectation that they will increase in value based on fundamental analysis.  Without factoring in valuations, abiding to basic rules of thumb can be a very costly mistake.  The government is spending trillions more each year than it is taking in from tax revenues.  This is highly inflationary, but it also props up the economy, at least for a time.  It’s a sugar high that won’t last forever.  At some point a recession will occur.  You shouldn’t fear it, or fail to invest due to its inevitable occurrence, but you want to invest in a manner that can survive a huge variety of potential outcomes, including those that are quite dire.  The reality is that certain bonds are actually one of the best ways to protect your portfolio if a recession were to occur, as they can rally when interest rates are expected to be cut, as is usually the case during a recession.  I know this was a lot of information, but I hope that you found it helpful if you made it through it all!

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