Although bond funds are attractive to investors because of their relative stability and diversification, many of the more conservative offerings in this category offer little or no protection from inflation.
Investors who seek to increase their purchasing power over time must therefore look to more aggressive sectors of the fixed-income market in order to stay ahead of the game.
Be sure to also read our Ultimate Guide to Bond Fund Investing.
What Is Inflation?
Simply put, inflation represents the constant increase in the price of goods and services in the economy. Inflation has historically grown at different rates during different periods; for example, it was extremely high under the Carter Administration in the early 1980s, but has slowed to a crawl in recent years. The prices of some goods and services, such as managed health care and higher education, have also grown much more quickly than other sectors of the economy.
But inflation in general serves to reduce the purchasing power of consumers in all areas over time.
This means that a dollar in 10 years will buy less than it can today. Therefore a bond fund that pays a steady rate of interest that remains at the same level over time will provide its investors with progressively less spending power in the future. Investors who want to increase their purchasing power over time with bond funds can therefore look to the following sectors of the fixed income market.
High Yield Bond Funds
There are both actively and passively managed funds that invest in several different types of high-yield instruments. These funds invest in issues that have been rated below investment grade by analysts and therefore pay a higher rate of interest. They typically yield one to two percent more per year than their more conservative counterparts, which makes them attractive to investors seeking to beat inflation over time.
Of course, they are also correspondingly more volatile because of their increased sensitivity to changes in interest rates. Some bond funds may also invest in CDs that are issued by big banks and distributed nationwide; these bonds typically pay higher interest than CDs offered by local banks and frequently contain “sweeteners” such as call or put features that increase their value. Other high-yield funds look for “fallen angels” that were initially given a BBB rating or higher but were subsequently downgraded for one reason or another.
Foreign Bond Funds
Many of the funds that purchase bonds issued by foreign investors also offer higher yields than comparative domestic issues. Some of these funds also focus on high-yield holdings in other countries while others invest more broadly, but the additional risk that comes from any type of international investing often comes with a superior yield. International bond funds can also help investors to balance out losses that will come when domestic interest rates rise, as these rates differ from one country to another.
One example of this is the GMO Emerging Country Debt IV Fund (GMDFX), which has posted an average annual total return of over 20% per year for the past 5 years. But it should be noted that while the default risk in this fund is lessened due to its diversification, the odds that one or more of the fund’s holdings could go belly up is probably much higher than that of a similar domestic fund.
Bond fund investors in the top tax brackets will often get a higher yield from funds that purchase muni offerings that pay tax-free interest. Some muni funds invest nationwide and pay interest that is only exempt from federal taxation, while others focus on a specific state or locality and offer double or triple tax-free interest. Investors must purchase funds that invest in their own domiciles in order to benefit from the latter type of fund.
These funds are offered in both ETF and open-ended form by several different companies. Eaton Vance has an open-ended offering for virtually every state in America.
These funds seek to at least keep up with inflation by purchasing Treasury Inflation Protected Securities, a special type of government bond that pays an interest rate which is periodically adjusted for inflation based upon the Consumer Price Index. These bonds come with a full guarantee of principal and therefore carry less risk than other types of bonds that can keep up with inflation.
Be sure to read the 25 Terms Every Bond Investor Should Know.
Another Way to Beat Inflation
Investors who want to beef up the returns they get from their bond funds can also do so by placing them inside tax-deferred accounts or plans such as traditional or Roth IRAs, qualified plans or variable annuity contracts. Any interest that is generated inside these vehicles is not reportable on the 1040 as long as the interest paid is not materially withdrawn and spent.
The Bottom Line
Bond fund investors who seek to beat inflation over time can achieve their goals by using a mix of strategies and focusing on a few specific sectors, such as high-yield or foreign bonds. Strategies like using tax-deferred vehicles and reinvesting your periodic interest payments can also increase returns in most cases over the long-haul.
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