Investment strategies for high inflation and rising interest rates

March 11, 2022 | Market news

A resurgence of inflation (7% annual rate in 20211) and the potential of higher interest rates could result in changes to the investment environment. If you’re contemplating adjustments to your investment and financial strategy in light of these developments, you’ll also want to keep tax considerations in mind.

The strategies to consider will depend on your financial objectives and the level of investment risk you’re willing to assume. This doesn’t necessarily mean that dramatic changes are required to your portfolio, but there may be opportunities to better position certain assets to capitalize on the evolving investment environment.

“If inflation is at 7% rather than 3%, people are losing purchasing power. This affects people at all wealth levels, and you should consider how your assets are positioned in light of that,” says John Campbell, senior vice president and central region managing director, wealth planning at U.S. Bank. “For example, with inflation at a high level and the potential to remain elevated, it’s not the time to have a lot of assets tied up in cash earning virtually no return.”

Following are strategies that have the potential to help you overcome the impact of higher inflation and rising interest rates.

Strategies for income-oriented investors

If you’re trying to determine how to generate income to meet current cash flow needs, you may find yourself facing significant challenges in a high inflation environment/low interest rate environment. Here are strategies to consider.

Gradually shifting money out of cash

If you have significant cash holdings, it may be beneficial to move those dollars incrementally into bonds and other types of securities that offer more attractive yields. Other investments you choose (including those listed below) won’t have the liquidity or safety of cash, but most likely will pay a higher rate of interest. To manage the added risk you accept by implementing some of the strategies below, it may make sense to periodically transition funds from cash to bonds or other securities you choose to help enhance your income stream.

Government-backed bonds with inflation protection

You have two primary options to consider:

  • Treasury Inflation Protected Securities (TIPS). TIPS are U.S. Treasury securities that are linked to changes in the Consumer Price Index (CPI), a widely recognized measure of the inflation rate. While the coupon rate (interest) paid by the security is stable, the value of the investment will increase and decrease with the rate of inflation. Increases in principal are taxable in the year realized, even though they are not paid out. There are a number of factors to consider when assessing whether TIPS are appropriate for your situation.
  • Series I Savings Bonds. These savings bonds must be purchased directly from the U.S. Treasury (electronically or utilizing tax refunds). The interest rate paid is adjusted twice a year based on the inflation rate (in early 2022, the interest rate on I-Bonds exceeds 7%). Investment limits are $10,000 per person per year and $5,000 per year using tax refunds. They are redeemable after 12 months, but an interest penalty of three months applies. After five years, there is no penalty for redeeming the bonds purchased.

Preferred stocks

With bonds still paying low interest rates in the current environment, preferred stocks offer another alternative to generate income and potentially take advantage of long-term capital appreciation. Preferred stocks are essentially a cross between an equity investment and a fixed income investment.

Preferred shares typically pay a fixed dividend and have priority status for dividend payouts over common shares of a company’s stock. Dividend payments are guaranteed but not always paid out on time. They also provide an opportunity to capitalize on appreciation in value of the company’s common stock if the preferred shares come with the ability to be converted into common stock. However, preferred stocks generally have no voting rights, while common stock do.

Similar to bonds, preferred shares have a par value which can be affected by interest rates, such that when interest rates rise, the value of the preferred stock declines. Preferred shares generally have a call feature which gives the issuer the right to redeem the shares from the market at a predetermined time. An opportunity can exist if the price of shares is at a premium to purchase price. Campbell suggests investors be selective in adding preferred shares to their portfolio, looking for companies that offer attractive value in the current environment (more on this in “Investing in select equities” below).

Fixed income securities

When interest rates rise, the value of existing bonds declines. “Investors should be cautious about putting money to work in longer-term fixed income securities given the expectation that rates are headed higher,” says Campbell. He recommends focusing on the shorter-end of the yield curve, with bonds that have terms no longer than three-to-five years. “Interest rate risk is reduced by maintaining shorter maturities, which is a primary concern in today’s environment,” says Campbell.

Laddering a series of bonds (from maturities of less than a year to maturities of up to five years) may be one option to consider. As shorter-term bonds mature, they can be invested in securities with longer maturities that typically offer higher yields. It provides a degree of liquidity as a portion of the portfolio reaches maturity periodically. While there is no guarantee over time, if interest rates head higher, the yield in the portfolio should rise.

“If inflation is at 7% rather than 3%, people are losing purchasing power. This affects people at all wealth levels, and you should consider how your assets are positioned in light of that,” says John Campbell, senior vice president and central region managing director, wealth planning at U.S. Bank.

Municipal bonds, particularly those from issuers farther out on the risk spectrum that offer higher yields, may be a timely consideration if you have money in a taxable portfolio. Credit fundamentals for most municipal borrowers today are solid, with many state and local governments in a strong financial position. This may make it an opportune time to seek higher coupon rates from lower-rated, high-yield municipal bond issuers.

Cash-equivalent investments

Cash vehicles (CDs, money market funds) have not been very attractive recently due to the low yields they generate. There may be opportunities to capture the benefits of rising interest rates in CDs or money market funds. If choosing CDs, you may want to consider shorter holding periods to limit interest rate risk and capitalize on higher yields by reinvesting proceeds of maturing CDs. Yields on money market funds generally fluctuate based on market trends, so if rates rise, there is the potential for earnings to improve. Money market funds generally offer more liquidity than CDs.

Real Estate Investment Trusts (REITs)

REITs can be an effective way to diversify an income portfolio in securities not tied directly to the interest rate environment. REITS typically generate cash flow from rental income earned on properties owned by the REITs. There’s also the potential for capital appreciation. Many REITs are registered with the SEC and are publicly traded, and there are also non-traded REITs. Some risks associated with non-traded REITs include the inability to trade these securities in the open market, redemption provisions that can be restrictive, difficulty in determining the value of a non-traded REIT, and the use of offering proceeds and borrowings to pay distributions. You should always review the initial prospectus and any supplements that will provide a more balanced and extensive discussion of risks involved.

If you’ve already invested directly in real estate, there may be a tax-efficient way to defer capital gains from the sale of those assets. You can utilize an Internal Revenue Code Section 721 Exchange of property held for investment or business purposes for shares of a REIT. This provides a more liquid and diversified real estate investment that defers capital gains taxes that would be realized from selling the property today. Before considering this type of exchange, you should consult with your tax advisor to ensure this is a suitable alternative for your specific circumstances.

Charitable remainder trusts to generate income

If you own appreciated assets with a low cost basis, consider establishing a Charitable Remainder Unit Trust (CRUT) or Charitable Remainder Annuity Trust (CRAT). The asset is gifted to an irrevocable trust. As the donor, you receive an income stream (it must be at least 5% of the value of the trust) for your life, the life of you and a joint beneficiary (usually a spouse), or for a set period of years.

An immediate tax deduction can be claimed based on the present value of the charitable interest that will be directed to the qualified charitable organization in the future. The charity will receive assets that remain after the death of the income beneficiary(ies) or at the end of the term of years income is paid out to the income beneficiary.

“The value of the deduction is based on the present value of the future gift to a charity. If interest rates are rising, the gift will be valued at a higher level, providing a higher tax deduction to the donor,” says Campbell. He points out that a minimum cash flow of 5% each year, from a charitable remainder trust to its income beneficiary, looks attractive in the current environment. In addition, there may be favorable tax treatment as a portion of the income stream could be taxed as long-term capital gains or qualified dividend income (with a tax rate of 15% or 20%) and as return of principal, which is tax free. “This can be an attractive strategy if you have charitable intentions and want to find tax-efficient ways to manage a highly appreciated asset,” says Campbell.

U.S. Bank and U.S. Bancorp Investments and their representatives do not provide tax or legal advice. Your tax and financial situation is unique. You should consult your tax and/or legal advisor for advice and information concerning your particular situation prior to establishing any trust.

Strategies for growth-oriented investors

If you’re seeking to generate growth in a portfolio, you should be aware that a higher inflation, rising interest rate environment can impact the performance of your investments. Here are strategies to consider:

Investing in select equities

Campbell notes that solid investment performance for the broader equity market may be more limited in the near term. “Active management of an equity portfolio may provide an opportunity today that you won’t find with investments in passive funds,” he says.

Campbell suggests focusing on stocks of quality companies in a strong financial position that are well-suited to deal with the inflationary environment. “Companies that are able to pass on the higher costs they incur to their customers will be able to maintain solid cash flow and operating margins in this environment,” he says. However, equity securities are subject to stock market fluctuations that occur in response to economic and business developments.

Maximizing 401(k) savings strategies

Do you typically “max out” your contributions to workplace savings plans (employee salary deferral is limited to $20,500 in 2022 for those under age 50, $27,000 for those age 50 and older)? If so, additional sums can be invested through employer matches and after-tax contributions for a maximum of $61,000 ($67,500 for those 50 and older).

You may also want to consider converting some of this money to a Roth IRA to generate tax-free growth of earnings. Note that if money remains in the 401(k) plan, it will be subject to required minimum distribution rules (currently effective at age 72).

Additional steps to consider

Beyond the investment and tax management strategies mentioned above, there are other steps you may want to explore to adjust your financial strategy to adapt to an environment with higher inflation and rising interest rates:

  • Pay down credit card debt. Look for ways to eliminate debts with high interest rates (which may be adjusted upward) to avoid facing higher expenses associated with this type of borrowing.
  • Seek more affordable borrowing options. If you aren’t able to pay off all of your debt, put a particular focus on loans that carry the highest interest rates and look to consolidate debts using a less expensive form of borrowing.
  • Invest in your own growth. Pursuing education or experiences that can enhance your ability to boost earnings can be a valuable way to protect your financial position.

Take action that’s appropriate for you

The current economic and market changes may not require dramatic alterations to your own asset mix or financial strategy. However, some adjustments may be worth considering. You’ll want to meet with your financial professional and potentially with your tax advisor to discuss strategies that are most appropriate for you.

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