Rising Interest Rates, Inflation, Bonds and the 60/40 Portfolio

Written by Ethan Pollard | April 20, 2022

With core bond indexes down nearly 6% in the first quarter and more than 7% since the end of 2020, investors are rightly questioning the role of fixed income within the context of their balanced portfolios. Inflation is rising at its fastest annual rate in 40 years, and recipients of fixed coupon payments are quickly seeing their purchasing power eroded.

Understanding interest rates, inflation, and bonds can be a challenge for most investors, and today's rising rates are leading to many questions on the impact of inflation on their portfolio. When it comes to inflation, bonds are one of the more rate sensitive investments and react the earliest to changes in interest rates.

In order to combat higher inflation, the Federal Reserve has already started lifting interest rates from the previous zero-bound, with short-term rates expected to approach 2% by the end of this year. A key tenant of fixed income investing is that bond prices and interest rates move in opposite directions; higher prevailing interest rates degrade the value of bonds previously issued at a lower rate.

With all this in mind, how are we helping our clients maintain an appropriate risk-balanced approach to achieving their long-term goals, while navigating this challenging bond market?

Below we highlight a handful of strategies that we are implementing in order enhance the fixed income portion of our portfolios:

Shorter duration: owning bonds with shorter maturities allows investors to reinvest proceeds at higher prevailing interest rates in a rising rate environment. By contrast, longer dated bonds are the last thing to own when rates are going up, as they are locked into a below-market interest payment for an extended period unless liquidated at a discount.
Lower credit quality: higher yielding corporate bonds tend to be more insulated from interest rate movements while offering a larger coupon payment to investors. In an environment where corporate balance sheets are healthy and the economic recovery remains intact, more exposure to credit makes sense.
Floating rate/inflation-protected bonds: these instruments are designed to increase payments to bondholders based on higher interest rates or inflation data, offering crucial protections in this current environment.

While core bonds remain a viable hedge against recession risk, we believe that supplementing our core fixed income holdings with the above strategies helps to fortify our client portfolios against a number of potential market outcomes.

When it comes to portfolio construction and allocation, we like to start with age, risk tolerance, and timeframe before getting down to the specific investments. These are variables that can be overlooked, but generally dictate the allocation mix in a portfolio.

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