Inflation Beating Fixed Income ETFs

In the face of mixed signals, investors should continue to be on the watch for macro indicators, like the aggressive stimulus package that has totaled US$ 2.2 trillion with a possibility of more on the way. This may eventually lead to higher inflation. Amy C. Arnott, a portfolio strategist for Morningstar, notes: “the Federal Reserve has been aggressively purchasing bonds and reducing interest rates. The government printing more money is basically a textbook cause of higher inflation because it decreases currency values.”

Arnott says a prudent approach would be to “carve out a portion of your portfolio to guard against different scenarios.” How? The first thing that comes to mind is to identify some direct targets of stocks or bonds that enjoy a boost when prices go up. It isn’t easy or cost-efficient to consider individual assets. Exchange-traded funds are among the low-cost solutions used widely by individual investors, especially first-time investors.

If you want solutions to buffer your portfolio from inflation risks, you could start your research here. We present two groups of ETFs (with Morningstar Analyst Rating or a Morningstar Quantitative Rating of Silver or better available in local or U.S. markets(, mainly with a bond-like return profile, that could bring you through the potential inflation upcycle.

Link with Inflation

Typically, once the inflation runs beyond the preset target, say set by the Fed, adjusting the interest rate becomes necessary to curb prices to rise exceedingly. Prices of fixed-income instruments would then become less competitive because higher-yielding alternatives are available. Thus, when inflationary pressure increases, ETFs that are intentionally correlated to the price hike become an option.

The Fidelity® Dividend ETF for Rising Rates (FDRR) is a vehicle for those seeking equity exposure that the dividend payout is not eroded by inflation and rate changes. The tracker invests in 130 large- and mid-cap dividend-paying stocks. It’s expected that these companies to grow their dividends with a positive correlation of returns to increasing 10-year U.S. Treasury yields. The Fidelity ETF has a strong track record of both long- and short-term, beating the Russell 1000 Value Index by an annualized 3.2 percentage points since its inception. The tracker also generates a higher Sharpe ratio over the trailing three-year period. It implies that in earning these strong returns, the ETF has not resulted in a bumpier ride for investors.

Treasury Inflation-Protected Securities (TIPS) is another straightforward way to guard against a potential increase in inflation in two ways. First, their principal value is tied to changes in inflation. Second, their coupon payments are also adjusted based on changes in the principal value. That implies that the total value of TIPS is adjusted to retain its real value. TIPS is backed by the US government, which will pay back at maturity either the adjusted par value or the original principal, whichever is higher. Earning a Gold Analyst Rating, Schwab US TIPS ETF™ (SCHP) and Vanguard Short-Term Inflation-Protection Securities ETF (VTIP) are affordable TIPS vehicles as they charge only 0.05% respectively.

Reduce Inflation Sensitivity

The second way to minimize the negative impact of inflation is to get around the inflation-sensitive assets. In bond investing, duration is a metric of how sensitive a bond is to interest rate risk. It is the weighted average of the time periods until a bond or bond portfolio's interest and principal payments are received, expressed in years. When interest rates change, the price of a bond will change by a corresponding amount related to its duration.

Morningstar senior fund analyst Matthew Wilkinson says: “The nuance here is the longer your maturity, the more affected you are by the change in interest rate.” He takes the average of the global aggerate bond index as an example, which on average has a maturity of seven years. “For example, if you have a maturity of seven years, you're more affected by interest rate rises than if you're in a product that has a maturity of less than seven.”

Adding short-duration bonds into a portfolio with ETF proves to reduce the overall sensitivity of interest rate changes at a low cost.

Gold-rated Vanguard Short-Term Corporate Bond ETF (VCSH), which charges a 0.05% expense ratio, provides diversified exposure to investment-grade corporate bonds with maturities ranging from one to five years. The strategy has considerable exposure to the financial sector. In terms of credit quality, approximately 43% of its assets were rated A and 48% were rated BBB, the lowest possible credit ratings for investment-grade debt as of end-March 2021.

On the index approach, Neal Kosciulek, Manager Research Analyst at Morningstar, says investing in higher-graded bonds with a cap-weighted index can accurately capture the composition of the opportunity set. “There is less room for active managers to find an informational edge here than in the high-yield bond market because the market knows with greater certainty what investment-grade bonds’ future cash flows will be.”

Alternatives with even shorter duration are available, such as PIMCO Enhanced Short Maturity Active ESG ETF (EMNT). The portfolio takes a very little interest-rate risk, with an effective duration of 0.71. It means, if there were a 1% change in rate, the bond's price would be expected to change by a minimal impact of 0.71%.

The portfolio is actively managed to invest in global issuers. The investment decisions support positive ESG outcomes by applying an extra layer of scrutiny in securities selection. The ETF invests in those issuers with improving-to-exemplary ESG practices and avoids those with deteriorating-to-harmful ESG traits. Miriam Sjoblom, Director of Fixed Income Manager Research at Morningstar, notes that this is a risk-averse solution that provides slightly better-than-cash returns, with a focus on maintaining a high degree of liquidity and minimizing volatility. She believes the product stands out among other actively managed competitors with a cheaper price tag (0.24% in expense ratio).

In Part II, we single out cheap ETF options in investing in two broad equity sectors that tend to follow the inflation hike cycle.

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