Will Inflation Crush Your Bond Portfolio?

If inflation picks up, will it crush your bond portfolio? That's a fear lots of investors have these days. Since history is one of our best teachers in finance, let's take a look at what happened to the bond market during the last period of run-away inflation, the 1970s. This may give us some insight into the risks we face in the current bond market.

On a calendar year basis, inflation in 1971 was 3.36% and it peaked in 1979 at 13.31%, so essentially a 10% rise in inflation over those 9 years. That's a lot of inflation, and one would expect that with inflation rising so fast, the bond market would have gotten hammered. Well, did it?

No, it didn't. According to Ibbotson data, the intermediate term government bond market did not have one negative year of total returns between 1971 and 1979.

• They define intermediate government bonds as a US Treasury bond portfolio with about a five year maturity.

In fact, here are the total returns for that bond market index, calculated by Ibbotson:

• 1971 8.72%
• 1972 5.16%
• 1973 4.61%
• 1974 5.69%
• 1975 7.83%
• 1976 12.87%
• 1977 1.41%
• 1978 3.49%
• 1979 4.09%

There are actually some pretty good bond market returns during those years when inflation was skyrocketing.

I don't bring up this period to argue that we won't see any negative years in the bond market going forward. I actually expect we will see some negative years because we are starting from rates that are so low. For instance, Ned Davis Research calculates that the duration on the aggregate bond market is about 5 today. That means if rates rose 1%, an investor could expect a 5% decline in price on their bonds for a portfolio that is designed to track the aggregate bond market. And if you're getting interest payments of about 3.5%, then you could see a 1.5% negative return for the year.

• Now, duration is just a theoretical number and markets don't generally play out as financial models assume they should. But it's a pretty good rough estimate of the pricing declines you could see from a rise of just 1%.

If you look at the 1970s, what you can learn is that if you keep your average bond maturity in the intermediate term range, say 5 to 7 years, then a cycle of rising rates should be reasonably manageable. Yes, the price of your bonds may go down to adjust to rising rates, but as your bonds mature, you should get your money back and have the opportunity to buy new bonds with higher interest payments. Buying and holding intermediate term bonds to their maturity is a prudent way to handle a potential rising rate environment.

If you follow a passive bond fund indexing approach, instead of owning individual bonds, the research indicates you should also experience a similar result, but the path is a little different. The price of the bonds in the index fund would fall if rates rose, but as new bonds are added to the index with higher interest payments, you get extra cash flow that helps offset the pricing declines. And if you are reinvesting those interest payments, you would in theory be buying more index shares each year with higher interest payments going forward. If you give the portfolio time, the extra cash flow from the higher interest payments should offset any prior pricing declines on your bonds.

I really have no idea what the next 10 years will bring us in the bond market or in the world of inflation. If you had asked me 10 years ago, I'm sure I would have given you an answer that wasn't reflective of where we are today. So you have to accept the uncertainty, and put into place a strategy that you think is reasonably manageable and that fits with what you need from your portfolio.

As we say in finance, past performance is no guarantee of future returns. But, the main way we understand market risks is to study past cycles, along with making informed judgments about what the future may hold. So take the historical data for what it is. There's no slam dunk answer on this, but you've got to make some informed decisions about your bond holdings.

Bottom line. Inflation may not be that challenging if you follow an intermediate term strategy for your bonds.

Above material does not constitute investment advice, is provided in summary format, and is not a complete analysis of the issue. Consult your individual financial advisor prior to making any financial decisions.

Learn More: Want to learn about a simple way to manage your personal finances and prepare for retirement, investigate my book Your Money Ratios: 8 Simple Tools For Financial Security, available in bookstores and at amazon.com The Wall Street Journal called the book "one of the best finance books to cross our desks this year." WSJ 12/19/09.

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