Inflation is defined as the rate at which the cost of goods and services is rising. Stated in the reverse, inflation is the rate at which the purchasing power of currency is falling. In this way, inflation is the risk to keeping your assets in cash. While the cost of goods and services increase, the $20 in your pocket remains worth only $20.
Although the percentage of annual inflation often sounds like a small number, inflation compounds and deteriorates wealth like a termite deteriorates wood. Unfortunately this year, inflation doesn’t even sound small.
Twelve-month inflation ending May 2022 is currently at an all time high of 8.58%, but there is debate whether inflation will continue like this.
Surprisingly, 41.76% of all the money we have ever printed has been printed since 2020, and we may not have felt the full effect of that yet.
On the other hand, investor expectations are that future inflation will be lower. One method of crowd sourcing expectations about inflation is to look at the current differences between the maturity rates of a 5-Year Treasury Bond and a 5-Year Treasury Inflation-Indexed Bond.
What to do?
Inflation can be something of a wild card. It has a volatility of its own and is not something that any of us can just wish away. It is an economic condition that ultimately affects the purchasing power of everyone’s cash. It is like the rain. You must prepare in advance — wear rain boots and a rain coat and carry an umbrella — in order to stay dry.
You should always be prepared for inflation. For that reason, we think inflation-protecting some of your bond allocation is normally a good idea.
Treasury inflation-protected securities (TIPS) increase their rate of return by the CPI-U inflation measurement. Semiannually, the bond’s par value increases by the same percentage as the CPI-U index. With the same coupon rate, a higher par value means more dollars of interest payments.
TIPS are an especially good idea if you think the market priced inflation expectation (currently 2.88%) is too low of an expectation.
Currently, the Inflation-Protected Bond ETFs on our Buy list are:
|Fund||Ticker Symbol||Expense Ratio||Average Effective Duration|
|Vanguard Short-Term Inflation-Protected Securities ETF||VTIP||0.04%||2.62|
|Schwab U.S. TIPS ETF||SCHP||0.05%||7.48|
It is good to have the option of investing in both shorter and longer term bonds. In our selections, VTIP is the short-term fund and SCHP is the longer intermediate fund.
Bonds with longer terms are the most vulnerable to losses from rising interest rates. This sensitivity is quantified in a bond’s effective duration, which states the percent loss this bond might expect from a 1% rise in interest rates.
To protect yourself from this interest rate risk, it is normally a good idea to stage the next few years of your upcoming withdrawals in short-term bonds. If you anticipate interest rates will continue to rise, then you may stage more in the short-term bonds. Otherwise, putting your later years of spending in longer term bonds will enable you to take advantage of the higher yield.
If you are not anticipating withdrawing from any of your investment accounts over the next 7 years, then you do not need a bond allocation. In fact, even compared to short-term TIPS, a portfolio of stocks is historically more likely to keep up with or surpass inflation.
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