William Lako: Fixed-income: preserve principal not maximize returns

With inflation at 9.1% and the markets having breached bear market territory in June, investors are worried. Quite honestly, right now, investors cannot beat 9.1% inflation without taking on excessive risk, especially in their fixed-income investments.

I recommend investors get close to inflation on their fixed-income investments to protect their purchasing power. Inflation has been below 2% for nearly 10 years. During that time, investors were able to get a 1.5% yield on 10-year Treasury bonds; however, inflation was also 1.5%.

When fixed income yields were low, it made sense to offset the management of fixed income to a professional manager by using bond funds. Bond funds have an active manager who can dabble with the quality of the bonds they buy and experiment with the duration of bonds to get the desired yield, which can be a good move short term, as investors could get nearly a 6% yield in 2020 and 2021. However, long term, bond funds have no predictable cash flows, nor do investors know what their investment will be worth when they need the money.

With the Federal Reserve raising interest rates, investors can now get bonds with two- or three-year maturities yielding 3%. If in two years inflation is back at the Federal Reserve’s target of 2%, the 3% bond is now beating inflation. With fixed-income investments, you are not trying to maximize returns. This money is placed in fixed-income investments to protect principal from stock market volatility, as the goal is to ensure this money is available when you need it. Investors should aim to get the most optimal, attractive yield they can find, and I recommend holding individual bonds until maturity. Ideally, investors can then use stock portfolios so that the asset growth can offset what they are not getting in fixed income yields and grow their wealth.

Ultimately this inflation will benefit companies’ revenue streams by passing higher prices to consumers, and profits will make it to companies’ bottom lines. Assuming price ratios remain stable over time as they have historically, stocks should grow as their earnings grow. Therefore, stocks are one of the best long-term hedges against inflation. Likewise, 9.1% inflation is not the norm, nor will it likely be this way long term. The Fed is actively fighting inflation to get us back to their long-term target of 2%. There are some signs in the Energy sector that inflation may be waning. Just as I’ve explained that the stock market’s long-term performance averages 10.5%, inflation averages 2%. We may not ever see a year with those exact numbers, but long term, we should see that trend.

I recommend investors assume inflation at 4.6% per year in their financial plans. Initially, that might seem very conservative considering the long-term average. However, investors who have done so now have some extra spending power from the 10 years that inflation was around 1.5%. Investors also gained more than 28% in the market last year, which is also offsetting the increased spending this year. Should inflation remain at 9.1% or higher for an extended period, you may consider moving to more conservative, higher inflation assumptions. You should review and update your financial plans at least every two years, allowing you to recalculate how inflation and spending have affected your long-term plans.