Inflation and Bonds

Bonds are often considered the “conservative” investment of choice.  They are guaranteed, so investors feel like they are prudent.  Prudence is folly if you will one day live on a diet of stale bread and Alpo.  Because most bonds have a predefined interest rate that doesn’t change over time, you are at a severe disadvantage in high inflation economic conditions and in conditions of rising inflation.

Treasury inflation-protected securities (TIPS) are a special type of U.S. Treasury note.  TIPS are like any other government-issued bond, except that the principal and coupon payments are tied to the CPI and increase to compensate for any inflation.  The math can get pretty complex, but these things do what they are supposed to do.  Don’t rush out and buy a bunch of TIPS just yet.  They may seem like a great idea, but they have underperformed similar assets over the past decade because interest rates are artificially low, and inflation hasn’t been a huge issue.  Low inflation has translated into an extremely low rate of return for these instruments.  Unless inflation rises and interest rates rise as well, these shouldn’t make up a major portion of your portfolio.  They do have an important place, however, in a risk parity portfolio.  We’ll discuss that in more detail in a later section.

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