How debt investors can deal with inflation

By Dhaval Kapadia | Jan 21, 2022

Low interest rates, rich stock valuations, coupled with inflation inching upwards, can play havoc on portfolios, especially retirees.

When it comes to the most insidious risks facing investors, inflation may well top the list.

The impact of inflation on portfolios doesn’t appear until investors compare gains to the climbing cost of living. To achieve any meaningful progress toward financial goals, investors need to clear the inflation hurdle.

  • Inflation is a well-known risk facing investors that must be taken seriously. Inflation, particularly at higher levels, has a devastating impact.
  • Since we can’t really predict inflation outcomes with precision, it helps to think along the lines of probability rather than forecasts.
  • Investors with shorter time horizons, who typically have greater exposure to fixed-return investments, are particularly vulnerable when inflation rises. A significant portion of the total return generated from bonds comes from income, which, for most bonds, is predetermined (hence the term “fixed” income). As inflation rises, the “fixed” income delivered by the bond is worth less. In response, investors may sell bonds, driving prices down and further hurting returns.

The Morningstar Investment Management team has come out with a report on how to position portfolios for 2022. Access the detailed report with visuals and data.

Meanwhile, the Morningstar Investment Management team in India explains where they are investing the debt portion of their managed portfolios.

Our domestic debt asset class research suggests that going ahead, investors will struggle to post significant gains in bonds as we are around the turning point of the current low-interest rate cycle. The annual return expectation from bonds would be more normalized as compared to high teen returns delivered in the last couple of years.

From a long-term perspective, we think bonds remain a necessary stabilizer for multi-asset portfolios, and medium-long duration bonds are likely to provide a cushion when equities sell-off as they offer attractive real rates. Based on our valuation implied return (VIRs) forecasts, the medium to long-term debt segment 5-10 years maturity looks relatively more attractive than cash and high credit quality short-term debt.

Accordingly, we are overweight medium to long term segment of the yield curve as it offers attractive real yield vs cash and short-term debt.

On the corporate bond side, credit spreads have also narrowed lately, compressing the net of expenses yield difference between banking PSU debt funds and credit risk funds. Although the absolute return expectation for credit risk is slightly higher due to better carry. However, one should be mindful of potential downgrades and defaults and their impact on the credit spreads which needs to be monitored carefully.

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