A Tactical Approach To Incorporating Bonds Into Your Inflation-Protected Portfolio

by: Ben Kramer-Miller

In my article Portfolio Strategy For An Inflationary Environment, I argue that owning bonds is a bad idea. I further argue that owning inflation protected bonds (i.e. TIPS (NYSEARCA:TIP)) is an equally bad idea, as the inflation protection that investors receive is only based on the CPI, which I believe understates inflation (see my instablog: Money, Inflation, And The CPI), and even if it doesn't, the funds investors receive to compensate them for what they lose to inflation are taxed, and so the structure of TIPS precludes it from providing inflation protection to investors

However, it is probably a good idea for investors to keep some of their assets in bonds and/or in bond funds. There are two reasons for this. First, while most bonds do not currently have good value, especially in the ongoing low interest rate environment, some do. Second, even bonds that do not provide great value can provide stability and capital appreciation under the right economic environment, and a tactical approach to owning and trading them may be very accretive, especially during temporary deflationary spikes.

In this article, I discuss my approach to bond ownership, given my conviction that there are strong inflationary pressures in our economy. In part one, I discuss some bond funds that offer good relative value to investors. These funds can be small core holdings in a portfolio that is built to withstand and benefit from an inflationary environment. In part two, I will discuss my tactical approach to U.S. government bond ownership. In particular, I will discuss long term treasury bonds (NYSEARCA:TLT). I argue that long term treasury bonds are overvalued, but there are situations that I believe will arise in the future during which investors will flock towards them as a "safe-haven" asset, especially if there is a bond or banking crisis outside of the United States.

1: Bond Funds Worth Considering As A Core Holding

Choosing a bond fund as a core holding is incredibly difficult in an inflationary environment. This is especially the case now given that bond prices are so high and interest rates are so low.

There are two approaches to enhancing one's returns in bonds:

  • You can find bonds that have higher yields, or
  • You can attempt to enhance returns through foreign currency appreciation by buying bonds denominated in foreign currencies that you believe will appreciate against the U. S. Dollar.

Both approaches come with their own risks. Bonds with higher yields have higher yields because the market perceives that there is a greater possibility that the issuers will default--either because they are a greater credit risk or because the bonds have longer durations. Bonds denominated in foreign currencies will be correlated to the values of these currencies relative to the U. S. Dollar, and there is the risk that the U. S. Dollar will appreciate against these currencies. Thus in choosing one's core bond holdings, one should diversify these risks.

In what follows, I suggest investors look at four bond funds as potential core holdings in their portfolios, keeping in mind that they are not inflation hedges; consequently, they should comprise only a small percentage of one's portfolio. I will discuss both "high yield" bonds and foreign currency denominated bonds.

A: High Yield Bonds

The Advisor Shares Peritus High Yield ETF

The most obvious approach to purchasing high yield bonds is to simply buy "junk" bonds, or bonds that are considered by analysts to have a higher risk of default: consequently, these bonds have higher yields. There are two common junk bond ETFs: JNK and HYG. Both funds have yields that are roughly 6.5%. Another option is the Peritus High Yield ETF: HYLD, which is a managed bond ETF.

Because HYLD is much smaller than its peers, its managers can invest in the bonds of smaller companies that large bond fund managers overlook, and they can consequently achieve a higher yield. While HYLD's high yield is reduced due to an admittedly outsized 1.35% expense ratio (JNK has an expense ratio of 0.4%, HYG's expense ratio is 0.5%), it manages to exceed 8%, which beats JNK and HYG by roughly 150 basis points. Furthermore HYLD has a shorter average duration than JNK or HYG, which implicitly means that it has less risk: HYLD has a duration of just 3.15 years, whereas JNK and HYG have durations closer to 4 years. HYLD also has the advantage of being actively managed, so that if some issues held by the fund run up in value, the managers can sell them and purchase other assets.

Undoubtedly the managers have taken advantage, as evidenced by the fact that while the monthly payouts for JNK and HYG have gradually diminished, those for HYLD have actually increased since the fund's 2010 inception. Despite these advantages, potential investors in HYLD should consider that the fund does take on some risks that bond investors might not be comfortable exposing themselves to. For example, HYLD is exposed to bonds of RadioShack (NYSE:RSH), which is a retailer that has been perpetually losing money. It is also exposed to a micro-cap oil producer--Connacher Oil & Gas (OTC:CLLZF)--which has also been losing money, and its shares trade at just 14 cents each. Nevertheless, these are small positions for HYLD, and there is no immediate threat of default.

U. S. Dollar Denominated Emerging Market Sovereign Debt

Another approach to achieving high yields without exposing oneself to foreign currency risk is to purchase one of the many funds that own U. S. Dollar denominated emerging market sovereign debt. These funds can yield from 4% - 5%. Emerging market sovereign debt is considered to be riskier than U. S. Treasury debt, despite the fact that many emerging market nations have far sounder balance sheets than the United States. Consider the following table in which I lay out the debt to GDP ratio of the United States and the top 10 countries represented by the PowerShares Emerging Market Sovereign Debt ETF (NYSEARCA:PCY)

(Data is from tradingeconomics.com)

Country Debt to GDP Ratio
United States 102%
Romania 38%
Sri Lanka 79%
Panama 36%
Mexico 43%
Indonesia 23%
Brazil 65%
Croatia 54%
Peru 21%
Columbia 32%
Lithuania 41%

While a national government's debt to GDP ratio is not definitive in determining its bonds' riskiness (for instance, a lot of these nations' debts come with (geo)political risks), these nations clearly all have cleaner balance sheets than the United States. In particular PCY has a distribution yield of 4.3%, which is not incredibly high; but considering that the fund has a duration of just under 10 years, and that the 10 year U. S. Treasury Bond currently yields, 1.72%, it yields 258 basis points more than the 10 year U. S. Treasury Bond with a better aggregate balance sheet. I wouldn't argue that PCY represents excellent value, but if one needs relative safety and exposure to U. S. Dollar denominated debt, it is not a bad choice.

B: Foreign Currency Denominated Bonds

Buying foreign currency denominated bonds in an inflation-protected portfolio gives investors the advantage of not having to take the risk of purchasing high yielding bonds, which come with the risk of a higher probability of default, because such investments are intended to increase in value through currency appreciation. Obviously such bonds are double-edged swords because foreign currencies can lose value.

I will not discuss foreign currency strategy here. I will merely suggest that countries that have a small national debt, and central banks with high bench mark interest rates should theoretically have strong currencies relative to countries that do not have these advantages. Unfortunately there aren't many bond ETFs that focus on just one country's bonds (outside of the United States), and so investors will have to consider funds that hold bonds in many countries as well.

PIMCO Australia Bond Index ETF

One single country bond fund that does exist and that is denominated in a currency that I predict will be strong relative to the U. S. Dollar is the PIMCO Australia Bond Index ETF (NYSEARCA:AUD). Australia generally fits the conditions I outline above for a strong currency, and where it fails it fares better than the U. S. Dollar. Since 2002, the Australian Dollar has roughly doubled in value against the U. S. Dollar. Australia's national debt to GDP is just 21%. Its benchmark interest rate is 3%, which is relatively high compared to the rest of the developed world.

Since its inception in November, 2011 AUD is up 4.5%, and most of this appreciation is due to the Australian Dollar's appreciation relative to the U. S. Dollar (over 3% since the fund's inception). In addition, the fund has paid a 3% coupon to its holders. If we assume that the Australian Dollar continues to appreciate relative to the U. S. Dollar longer term, then not only will this appreciation show itself in the principle value of the fund, but it will also inflate the fund's monthly distribution, making this fund attractive to bond investors who are concerned about inflation.

WisdomTree Emerging Market Local Debt Fund

Unlike PCY, which holds emerging market debt denominated in U. S. Dollars, the WisdomTree Emerging Market Local Debt Fund (NYSEARCA:ELD) holds emerging market debt denominated in local currencies. Emerging market currencies may seem risky, but when considered in the context of the aforementioned metrics for a relatively strong currency many of them fit the bill. Consider the following table where I give these metrics for the 10 most heavily represented countries in ELD.

Country Benchmark Interest Rate Debt To GDP Ratio
Mexico 4% 43%
Malaysia 3% 53%
Indonesia 5.75% 23%
Brazil 7.25% 65%
Turkey 5.5% 39%
Russia 8.25% 10%
Thailand 2.75% 42%
South Korea 2.75% 34%
Poland 3.25% 56%
South Africa 5% 41%

The fund currently has a duration of just under five years. Given that it has a yield of nearly 4%, it yields more than 300 basis points more than the 5 year U. S. Treasury Note. This fund is probably riskier than AUD, as the higher yield indicates. However, as the above data shows the currencies that ELD is exposed to are in a position to appreciate, and I doubt that there is any significant risk of these countries defaulting in the foreseeable future.

Incorporating The Long Bond Into Your Inflation-Protected Portfolio

The precise role of the 30 year U. S. Treasury Bond in a portfolio that is built to withstand inflation is, on the surface, non-existent. First, I would argue that bonds are fundamentally over-valued. The 30 year U. S. Treasury Bond yields just 2.87%. If one pays a 47% tax rate including federal and state taxes, then the actual yield is a mere 1.52%, which is below the rate of inflation, even if one assumes that the CPI is accurate. Furthermore, the total supply of U. S. government debt is increasing rapidly: currently at a rate of more than $1 trillion per year. While there is demand for long term government debt coming from the Federal Reserve, the fact remains that the U. S. government's ability to repay its debts decreases as these debts accumulate.

Second, conventional wisdom suggests that long term government bonds will increase in value during periods of deflation, as was the case during the 2008 financial panic, or during periods where safe haven assets are in demand. However if we consider the performance of long term government bonds over longer periods of time, this correlation cannot be demonstrated. In fact, long term government bonds do not seem to be correlated with any major asset if we extend our timeline enough; and they have appreciated and depreciated in value during periods of inflation. Let us look at the last 40 years or so to illustrate this point.

Consider the following long term chart of the interest rate on the 30 year U. S. Treasury Bond.

Bonds were in a bear market from about 1940 through 1980, with the 1970s being the culmination of this bond bear market, during which time inflation spiked into the double digits and fears that the U. S. dollar would collapse peaked. During the 1970s, bonds were inversely correlated with commodities, which experienced a bull market, and they were not correlated with stocks, which traded in a range. However, given the inflationary environment, one could argue that stocks as an aggregate were in a bear market insofar as they lost purchasing power. Thus in the 1970s, bonds and stocks were actually correlated, while both bonds and stocks were inversely correlated to commodities.

From the end of this cycle at the beginning of the 1980s through roughly the year 2000, stocks and bonds remained correlated; both experienced bull markets. Commodities entered a bear market, and they remained inversely correlated to both bonds and stocks.

Thus from 1970 through the bursting of the NASDAQ bubble, we see a similar pattern: stocks and bonds were correlated, while commodities traded in the opposite direction. Since the bursting of the NASDAQ bubble, stocks began trading sideways, but in terms of their purchasing power, they have lost value, while commodities bottomed around 2000-2002 (depending on the particular commodity), and moved upwards. However, while the price action in bonds relative to stocks and commodities from 1970 through 2000 would suggest that bonds should have begun to move lower, they resumed their upward march and broke with previous trends; they became correlated to commodities and inversely correlated to stocks, although this correlation to commodities is in direction only, as the magnitude of the rise in commodities far outpaced that of the rise of treasuries.

This enigmatic price action in the long term government bond market relative to other assets precludes me from giving them a core role in my portfolio, especially given my concerns regarding inflation.

However, from a longer term trading perspective, long term government bonds are still in an uptrend (rates are in a downtrend), as the following chart of 30 year bond rates illustrates:

Consequently, a trading position can be assumed when 30 year U. S. Treasury Bonds undergo a correction that does not break this trend.

Furthermore, from a shorter term trading perspective, long-term government bonds can play a role in an inflationary portfolio as a hedge against deflation, as recent deflationary spikes, such as those in 2008 and 2011, have come with spikes in the value of long term government bonds. Putting just ten percent of one's assets into long term government bonds when they are slightly out of favor can be enormously beneficial, as the price action in bonds vs. core assets in an inflation-protected portfolio. During the deflationary spike from September 2008 through December 2008, long term government bonds increased in value by roughly 30%, whereas inflation hedges fell by roughly the same amount.

A $1,000 portfolio that held just inflation hedges would have fallen to $700, while the same portfolio with 10% of its funds in long term bonds would have fallen to $760. The funds that were in long term treasury bonds increased nominally by 30%, but they increased 86% relative to a commodity or stock that fell by 30%. Of course such a strategy requires impeccable timing capabilities, which yours truly lacks. However, simply allocating some of one's assets into the long term government bond market when market sentiment overwhelmingly favors inflationary assets, or when there are fears that there will be a banking crisis that have yet to inflate bond prices, generally has proven to be accretive in the recent past, despite the fact that the fundamental quality of long term government bonds is questionable.


Readers should take away the following points from this article:

  1. In general bonds do not offer good value in the current inflationary environment. However investors should consider holding a small percentage of their assets in select bonds or bond funds.
  2. There are some exceptions to this observation. Investors should consider some high yield bonds or bond funds, such as HYLD.
  3. Investors should also consider purchasing particular foreign currency-denominated bonds from countries with low debt to GDP ratios and a high benchmark interest rates. The PIMCO Australia Bond Index Fund and the WisdomTree Local Currency Emerging Market Debt Fund are funds that investors should look into.
  4. Long term U. S. Treasury Bonds are fundamentally overvalued because they offer low interest rates and are in high supply. However there are scenarios in which investors will benefit significantly from owning them, especially as long as they remain in a long term uptrend.
  5. When investors are concerned about short-term deflationary pressures, or when they are concerned about banking or sovereign debt crises that have yet to inflate Treasury prices, they should consider purchasing long term U. S. Treasury Bonds for a trade.

Disclosure: I am long HYLD. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.