The Hunt For Yield: Navigating Inflation And Rate Risks

Inflation and rising interest rates can be challenging for investors, but some investments tend to fare well during these periods. Commodities, gold, silver, real estate, and certain stocks are all options that can help protect your portfolio from rising inflation.

Inflation-indexed bonds, such as Treasury Inflation-Protected Securities (TIPS), are designed to protect your investment by adjusting the interest rate periodically to keep up with inflation. They are a popular choice in a high-interest environment.

Diversifying your portfolio is always a good strategy, and this holds true during inflation and rising interest rates. A diversified portfolio will include a mix of stocks, bonds, cash, and alternative investments, such as real estate or gold, that perform differently under varying economic conditions.

Additionally, investing in banks, brokerage firms, cash-rich companies, and companies with pricing power, such as food staples or gasoline, can be beneficial. These companies can raise prices without sacrificing demand and are likely to benefit from rising interest rates and inflation.

Finally, consider investing in short-term or floating-rate bonds to reduce portfolio volatility.

Gold

However, the relationship between gold and inflation is nuanced, and gold's performance is complex and dependent on investor behaviours and economic conditions. The mere expectation of inflation can be enough to drive up gold prices. If investors believe inflation will increase in the near future, they may buy gold in anticipation, creating a self-fulfilling prophecy as rising demand drives up the price of gold.

Despite gold's mixed performance, it can still be a strategic addition to portfolios during inflationary environments. Most experts recommend keeping a 5-10% allocation to gold within a diversified portfolio to provide inflation protection without overexposure to a single asset. Gold has historically had a low or negative correlation to stocks and bonds, suggesting it offers value as a tool for diversification.

Real estate

Firstly, real estate offers a mix of high-value stability and a high chance of value increase. Property values tend to keep pace with inflation, and as inflation pushes prices upward, rents included, landlords can generate higher revenues. Moreover, as housing development slows and demand for existing properties rises, occupancy rates typically skyrocket, allowing landlords to raise rents.

Secondly, mortgage payments on fixed-rate instruments remain constant over time, while equity growth accelerates. Inflation also reduces the value of money owed in the future.

Thirdly, real estate investments have a degree of illiquidity, which can be advantageous during inflationary periods. Real estate investments cannot be quickly and easily sold without a substantial loss in value, which means that investors are more likely to hold on to their investments and ride out temporary fluctuations in the market.

Additionally, real estate provides a stable income stream. Real estate investment trusts (REITs), for example, are companies that own and operate income-producing real estate. As property prices and rental income tend to rise with inflation, REITs pay out dividends to investors.

Finally, real estate investments offer tax advantages. Rental real estate owners are allowed to depreciate the value of their property on their taxes, which helps offset taxes owed on rental income. There are also opportunities to save on taxes when selling property, such as through a 1031 exchange, which allows investors to roll the proceeds from the sale into a similar property without owing capital gains taxes.

Inflation-indexed bonds

For example, if you invest $10,000 in inflation-indexed bonds with a promised 2% real return, and the inflation rate reaches 5% for the year, the principal of the bond would be increased to $10,500. At maturity, the bond would pay you interest equal to 2% of $10,500, or $210 in this case. Thanks to the inflation adjustment, you preserve the purchasing power of your money and also earn a 2% return.

Pros of Inflation-Indexed Bonds

Fixed long-term yield: Inflation-indexed bonds offer a fixed, long-term yield, appealing to investors who want the stability of a fixed-income investment but are worried about the impact of inflation.

Zero inflation risk: These bonds have no inflation risk, meaning your investment is protected against rising prices. This is in contrast to conventional bonds, which can lose value in real terms if inflation rates rise.

Returns are not linked to the market: The return on inflation-indexed bonds is not correlated with the returns of the stock market, so they can provide a hedge against inflation and valuable diversification.

Cons of Inflation-Indexed Bonds

Less earning potential than other securities: Inflation-indexed bonds have less earning potential than other securities such as stocks because they offer a fixed return, while other securities offer the potential for higher returns. Additionally, if inflation rates are low, you may not earn as much as you would with a different investment.

Not a perfect measure of inflation: While CPI is the most common measure of inflation for US inflation-indexed bonds, it is not a perfect metric. Some experts warn that there is some uncertainty regarding how well these bonds will protect investments from price rises.

Phantom income: In the US, phantom income refers to unrealised gains on investments that are not subject to current taxes. With inflation-indexed bonds, phantom income can occur when the CPI rises and the value of the bond increases.

Consumer staples

Consumer staple stocks usually have steady but low growth, with the goods sold by these companies in demand year-round. As a result, they are less impacted by business cycles, allowing them to stay strong during downturns or high inflation. Companies in this sector can also raise their prices more easily due to the steady demand.

During inflation, consumers may cut back on discretionary purchases such as restaurant meals and subscriptions but will continue to buy basic necessities like food and hygiene products. This is reflected in the performance of consumer staples stocks such as Campbell Soup, Kellogg, Coca-Cola, and Hershey, which have posted gains during inflationary periods.

Silver

However, it is important to note that silver is a volatile investment option. The price of silver is influenced by various factors, including supply and demand, economic trends, the strength of the US dollar, and government policies.

Frequently asked questions