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Robert Powell: What is inflation doing to my short-term investments?

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Historically low interest rates have been problematic for older investors who wanted to live off the interest income from money-market funds, CDs and bonds. 

For years, those investments yielded next to nothing.

But now, inflation as measured by the consumer prices index (CPI) is rising 5% per annum and retirees might consider repositioning not just their long-term investments (as I wrote about recently) but their short-term investments as well.

What to consider?

Read: Inflation is surging. How high will it go? Check our inflation tracker

Should you even tweak your portfolio? Whether you reposition your portfolio depends on whether you’re betting on higher or lower inflation in the near term, according to Patrick Kuster of Buckingham Strategic Wealth.

“If you currently own investments that are subject to inflation risk and think inflation may be more than is currently reflected in the markets, it may make sense to reallocate to similar investments that may offset some inflation risk,” he said. “That may mean considering the sale of some high-quality bonds and buying some TIPS of the same duration.”

Want to learn more about retirement? Check out MarketWatch Retirement

Real returns are negative but for how long? If you subtract the yield on, say, a money-market fund (0.01%) from the current rate of inflation you get a negative real rate of return (call it -4.99%). That means your money isn’t keeping pace with inflation.

“Given the low level of interest rates currently and the unusual situation of inflation rising quickly creates a negative real yield situation,” said Steven Gattuso, the chief investment officer of Courier Capital. “Historically this upside-down situation should not last indefinitely.”

How long the upside-down situation lasts might be an unanswerable question. But one question experts can answer is this: What’s driving the increase in CPI?

“It’s important to unpack the inflation report to understand where prices are going up,” said Rafia Hasan, the chief investment officer of Wipfli Financial Advisors. “The inflation report from this month is heavily impacted by base effects from last year,” she said.

According to Jeff Witt, the chief investment officer of Private Asset Management, author of a recent blog on the topic, there are many factors that are pulling inflation in opposite directions, which is why there is still a big debate as to whether inflation will be transitory or persistent.

“Still, a 5% headline increase over the past year at a time when one-year U.S. Treasurys are yielding 0.04% tells you that staying in safe-haven assets means you are losing out on purchasing power over time,” said Hasan.

Read: Where should I retire?

Safety first. Retirees, unfortunately, have few choices when it comes to maintaining their purchasing power without taking on more risk. “They are between a rock and a hard place with interest rates so low and inflation rising,” said Blair duQuesnay, a certified financial planner at Ritholtz Wealth Management.

According to duQuesnay, the best place for short-term money is still cash, money-market funds, or savings accounts. “Even at painfully low interest rates, it is not worth the risk to try to get more yield where price volatility introduces the risk of decline in principal,” she said.

Read MarketWatch’s inflation coverage

Others agree that keeping money you need in the short term, say for living expenses over the next 12 to 24 months, in safe safe-haven investments and investing money you’ll need in the long term in risky assets is the best strategy.

For instance, money earmarked for an emergency fund, unplanned expenses or near-term big-ticket expenses should stay in a money market account or, better yet, an online savings account, said Greg McBride, the chief financial analyst at Bankrate.com. “While the top yields hover near 0.5% and trail the rate of inflation, the federal deposit insurance and ready access when needed make this a must-have,” he said.

Consider supplementing your liquid reserves with a rewards checking account and Series I savings bonds.

A rewards checking account, McBride said, won’t be a fit for everyone, but can deliver higher, risk-free yields while preserving access to liquidity. “These accounts typically require 10-12 debit card transactions per month, direct deposit, online bill pay and online statements to earn the stated yield—which can be 2.5% – 3%,” he said. “However, this higher yield is capped, often at balances between $15,000 – $25,000.”

I bonds, meanwhile, are at least guaranteed to protect your purchasing power by mimicking increases in the CPI, however you cannot cash an I-bond at all in the first 12 months and will forfeit three months of interest if cashed within five years. Annual purchases are limited to $10,000 and the current rate on I bonds is 3.54%.

Jeffrey Nauta, a principal with Henrickson Nauta Wealth Advisors, also favors I bonds for investors that have a 12-month-plus time horizon. Of note, he said the interest rate on I bonds readjusts every six months based on an inflation rate and even though you are limited to a $10,000 investment per person you can increase that amount by $5,000 each year by redirecting a portion of your federal tax refund, he said.

Others are also focused using short-term investments and strategies in the current environment. Floating rate Treasury funds, short-term Treasury funds, and laddering Treasury securities allow reallocation if rates increase, said Jeffrey Augustine, a certified financial planner with Augustine Financial Solutions. “Safety trumps yield, particularly if a client is already fully allocated to equity,” he said.

What if inflation rises above Fed’s guidance? Gattuso is also leaning more toward safety with his short-term safe-haven investments. For instance, he’s keeping duration (the time it takes to recover half the present value of all future cash flows from a bond) “very short” but he’s also focusing on the potential for inflation rising quicker than the Federal Reserve is guiding.

Gattuso offered the following investment options to consider:

SPDR Bloomberg Barclays Investment Grade Floating Rate ETF
FLRN,
+0.03%

and iShares Floating Rate Bond ETF
FLOT,
+0.04%
,
both of which are investment grade floating rate ETFs. According to Gattuso, the yields (0.22% and 0.18%, respectively) are better than a two-year Treasury (0.14%) but have protection should interest rates rise quickly and with a duration of about 0.25 years has little risk.

Janus Henderson Short Duration Income ETF
VNLA,
.
This fund, according to Gattuso, has a duration around one year but a distribution yield (0,92%) similar to a five-year Treasury (0.75%). “Also, it’s a high-quality portfolio that has international exposure for further diversification,” he said.

BMO Ultra Short Tax-Free Fund Class I
MUISX,
.
Gattuso said he uses this ultrashort municipal bond fund for high income clients where the tax-equivalent yield is even better. The current tax-free yield on this fund is 0.17%.

And for direct inflation protection, Gattuso is using shorter TIPS funds or real return funds for more direct purchasing power protection while still getting an income distribution.

Others favor TIPS as well. For instance, David Hultstrom, the co-founder of Financial Architects, suggests iShares 0-5 Year TIPS Bond ETF
STIP,
+0.12%

as one such short duration TIPS fund. “Wishing there was a better option, or wanting better returns doesn’t cause them to exist,” he said.

Kevin Grogan, managing director of investment strategy for Buckingham Wealth Partners, also thinks investing in short-term TIPS is the best way to position a portfolio for short-term spikes and unexpected inflation. Yes, you’re locking in a negative real return but “if inflation winds up coming in greater than what the market expects you’ve got protection against unexpectedly high future inflation.” His choice: Vanguard Short-Term Inflation-Protected Securities ETF
VTIP,
+0.13%
.

Nauta agrees that investors should look to shorten duration on their fixed-income holdings but resist the urge to move down the credit spectrum.

Of course, some do suggest moving down the credit spectrum to pick up some yield. For instance, Witt said the current low interest rate environment means that bond prices are elevated, and yields are low. “This creates a higher degree of interest rate risk, with longer duration bonds the most price sensitive,” he said.

Given that, an investor might consider selling their longer duration bonds and replacing them with a diversified high yield investment, said Witt. High-yield investments tend to be shorter in duration.

Additionally, retirees might consider an investment in a senior secured loan portfolio, which traditionally have variable interest rates and are also shorter in duration, said Witt. These changes would help maintain a portfolio’s yield, while reducing its risk to higher interest rates and inflation, he said.

For her part, Hasan said there are two factors on the bond side that drive returns: term risk and credit risk. “For investors who are willing to tolerate a little more risk they can either increase the duration of their portfolio i.e., move from a money-market fund to a short-term bond fund and/or increase the credit risk i.e., investing in bond funds that have exposure to higher yielding bonds,” she said. “The key is to do this in a diversified manner by holding funds instead of individual bonds.”

What if you have a longer time horizon? As for investors with a time horizon of three or more years, Nauta said there are a number of private credit funds that forgo daily liquidity in return for higher yields. Those include funds such as Variant Alternative Income fund (NICHX), which focuses on niche private lending, targets a distribution of 6% and was down approximately -1% during the coronavirus equity market drawdown in 2020, or the Cliffwater Corporate Lending fund
CCLFX,
,
which is yielding approximately 7% and was down approximately -4% during the 2020 selloff.

As for the equity portion of the portfolio, if inflation proves persistent, then it would be good to have exposure to companies that have pricing power and can pass along their higher input costs, said Witt. “Additionally, growth stocks, who’s intrinsic value is based on future profits, could be more at risk to an inflationary environment,” Witt said. “This is because the present value of their anticipated earnings would be lower due to higher inflation.”

There’s also been a noticeable degree of sector rotation this year as investors already appear to be repositioning portfolios away from growth sectors. “However, since the debate regarding whether inflation will be transitory or persistent is ongoing, this reposition could quickly reverse course,” Witt said.

Bottom line for Witt: “Since the debate regarding inflation is far from certain, we would not think it is prudent to make major changes to a portfolio now. This issue will likely be with us for the rest of 2021 and it will be important to watch various market and survey indicators to better understand if a new inflationary regime is taking over.”

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