When inflation is on the rise, it can be difficult to know what to do with your money. You may be worried about losing the purchasing power of your savings. However, there are steps you can take to protect your retirement savings from inflation. One option is to invest in bonds. But with so many types of bonds, which ones should you choose? In this blog post, we'll break down three major types of bonds—municipal bonds, I-bonds, and bond funds—to help you make a decision.
Inflation and Bonds: what you need to know
Any investor looking to protect their retirement savings from the effects of inflation should consider bonds. Bonds may not be the most attractive strategy, because they offer relatively fixed payments, but they keep up with the rising cost of living. A lot of people think investing is all about picking the right stocks. But if you want to preserve your capital, it's crucial to diversify your portfolio and include both stocks and bonds.
Bonds may not provide the highest return, but they offer greater stability and security. When interest rates rise, the market value of bonds falls, but this effect is offset by the fact that the payments on bonds can increase (if you’re using a bond mutual fund). While the stock market may suffer during these times, bonds tend to fare much better as a source of regular retirement income.
Bonds can be designed in different ways:
- Even though the payments on individual bonds are fixed, they can still be higher than the rate of normal inflation.
- Interest payments on certain bonds are often index-linked, which means they keep pace with inflation. As a result, you can maintain your pre-retirement standard of living even as everyday prices increase.
If you need to rely on investments for retirement income (or will in the future), bonds should be a staple in your portfolio.
Long-term or short-term?
It's important to remember that long-term bonds are more sensitive to inflation and interest rate changes than short-term bonds. This makes short-term bonds best for retirees who are approaching the asset drawdown stage of their investment, and who intend to cash the bonds before the market has a chance to erode the value of their bonds. But if you're planning on holding your bonds for the long haul instead, it's important to keep your eye on inflation rates and make sure that you are diversified across different types of bonds.
3 Types of Bonds to Help You Survive High Inflation
1. Municipal bonds
Municipal bonds are issued by state and local governments as debt securities to finance public projects, such as roads, schools, and bridges. They are called "munis" for short. Municipal bonds are sometimes subject to state and local taxes but are typically exempt from federal taxes. You will not have to pay taxes on the interest income you earn from munis, but you must report this income on your tax return. Municipal bonds are an attractive investment for people who are in a higher tax bracket and want to minimize their tax liability. However, municipal bonds may be riskier than other types because the issuer (the local government) could default on the bond.
I-Bonds are savings bonds that are issued by the US Treasury. They are very safe investments because they are backed by the full faith and credit of the US government. I-Bonds provide a fixed rate as well as a variable rate based on the Consumer Price Index (CPI). Interest is adjusted for inflation every six months. I-bonds are subject to federal taxes but are exempt from state and local taxes. This makes them a good choice for investors who want to hedge against inflation but who don't want to pay state and local taxes on their investment income.
Two downsides are that an investor is capped at an annual $10,000 investment and it can only be done through the US Treasury’s website.
3. Bond Funds
Bond funds are investments that pool together money from many different investors and then invest that money in a portfolio of bonds. Bond funds offer diversification and professional management, which can make them a good option for investors who want exposure to the bond market but who don't want to manage their own bond portfolio. This is a good idea, given that individuals have subjective blind spots, like the money illusion, and can make rash emotional decisions during swings. However, bond funds are subject to market risk, which means that their value can go up or down depending on economic conditions.
Stocks and Bonds: getting the balance right
A portfolio that includes stocks and bonds will be easier to stomach than one that consists solely of stocks, and is better positioned to provide a more reliable stream of income in retirement. A traditional recommendation for retirees is a 60/40 stock/bond ratio, but this will be different for each investor's situation. As you approach retirement, it's important to understand what other sources of income you have outside of your portfolio, and design your portfolio around this and your long-term goals. The right asset allocation will vary depending on factors such as your age, risk tolerance, and goals. Each investor's circumstances are unique, so you should speak to a financial advisor to get tailored advice.