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Tips for Careful Bond Buying as Interest Rates Rise

Kevin BrosiousBy Kevin P. Brosious, CPA, PFS, CFP

The current dividend yield of the SPDR S&P 500 index (SPY) is 1.3%, this is calculated using the four most recent quarterly dividends divided by the current price of SPY (~$436). The 10-year Treasury note is yielding 2.2%, not too exciting either in a 7% inflation environment. However, an investor’s yield is calculated by using the cost of the security when it is purchased. Therefore, if you purchased SPY 10 years ago for $135 per share, your yield on those shares is 4.2%, not 1.3%. Also, the dividend distributions for SPY had an annual compound growth rate of 8.3% for the past 10 years, so you were collecting a dividend that was increasing annually. This is not the case for bonds that are fixed-income securities with coupon payments that remain the same for the life of the bond.

In addition to an increasing dividend yield, your investment in SPY grew 3.5 times since 2012. So, not only did you get paid a dividend stream that exceeded the inflation rate, but your investment also grew significantly. However, if you hold a bond to maturity, you’ll collect only the periodic interest payments and the par value of the bond at maturity, nothing more. And the market value of your bond principal is most likely to fall as the Federal Reserve carries out its plan to increase rates in 2022 and beyond to fight inflation. Remember, interest rates and bond principal move in opposite directions.

Woman reviewing pages of investment options.Low bond yields and the chance of having your principal fall when interest rates increase make bonds increasingly unappealing as an investment. However, they do provide stability to a portfolio during times of stress for stocks, so they are still a necessary component of a balanced portfolio. But how can you add bonds to a portfolio without subjecting them to losses as interest rates increase?

Buying short-term or floating-rate bonds is a consideration when interest rates are rising. Short-term bonds have less interest rate risk than longer-term bonds, and floating-rate bonds have near zero interest rate risk, so they won’t lose value during periods of rising rates. A floating-rate bond has a variable interest rate that rises as interest rates increase, as opposed to all other bonds that have a fixed coupon rate of interest.

Consider inflation-adjusted bonds like Treasury Inflation Protected Securities (TIPS) or Treasury-issued iBonds. TIPS can be purchased via Treasury Direct or through any broker, and are available for purchase in exchange traded funds (ETFs) or mutual funds. TIPS provide a “real” inflation-adjusted return to investors through principal adjustments based on the Consumer Price Index (CPI). So, if you purchased $100,000 of TIPS and the CPI increased 7%, your investment would be worth $107,000 after the inflation adjustment and your coupon payments will be based on the inflation-adjusted principal amount.

The TIPS yield is calculated by subtracting an investor’s expectations about future inflation from the current yield of a Treasury bond (Treasury yield – Inflation expectation = TIPS yield). As of March 16, 2022, the 10-year Treasury is yielding 2.2% and market inflation expectation is 2.84%, so 10-year TIPS are yielding -0.64%1. The expected inflation is also known as the breakeven inflation rate. So, if inflation averages more than 2.84% per year, then the TIPS would return more than the Treasury note; if inflation is less than 2.84% and the Treasury note would provide a higher return.

As with all bonds, don’t expect TIPS to provide any income above the inflation rate. With a negative real yield, the most you can hope for is to keep pace with inflation, not beat it.

To earn both a fixed rate of interest and an inflation rate of interest, consider iBonds. The fixed rate of the iBond stays the same for the life of the bond, but the inflation rate is reset twice a year. The current fixed rate is 0% and the inflation rate is 7.12%: this will apply to bonds purchased through April 2022. Again, with a zero fixed rate, don’t expect these bonds to provide any return above the level of inflation. However, your nominal return can still be positive, and in this case would be a whopping 7.12% for the first six months, well above any other bond issued by the federal government and most corporate bonds. iBonds can only be purchased via Treasury Direct, and purchases are limited to $10,000 per person per year, plus an additional $5,000 if purchased with tax return refunds.

The tax features of iBonds are also attractive. Like TIPS, interest is exempt from state and local income taxes, and you can defer the iBond federal tax on the interest until you cash your bonds in. Also, if used for education purposes, iBond interest may also be exempt from federal income taxes.

Some investors might also consider junk bonds for their portfolio. Junk bonds are bonds rated less than a BBB by S&P or Fitch, and usually pay a much higher coupon rate of interest than investment-grade bonds. Junk bonds are currently paying ~2% more than investment-grade bonds with similar maturities. However, investors should be aware that junk bonds won’t provide the stability of other bonds during times of market stress, as evidenced by their 40% drop during the 2008-2009 credit crisis. And isn’t stability the reason for adding bonds to your portfolio in the first place?

1 As of Jan. 16, 2022. TIPS yield is a “real” yield, meaning the nominal yield minus inflation. Because of Federal Reserve intervention, most bonds are yielding a negative “real” return.

Kevin P. Brosious, CPA, PFS, CFP, is president of Wealth Management Inc. located in Allentown and Plymouth Meeting, Pa. He can be reached at kevin@wealthmanagement1.com.

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