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- With inflation on the rise, participants in defined contribution (DC) plans need options for preserving purchasing power in retirement.
- Traditional inflation hedges are often highly correlated with fixed income.
- Retirement investors may wish to opt for non-traditional inflation hedges like high yield bonds and leveraged loans which offer lower to little duration risk, respectively, and a low correlation to investment grade bonds.
- High yield bonds and leveraged loans offer additional benefits, including enhanced diversification, relatively attractive yields, lower volatility than equities, and the potential to generate strong risk-adjusted returns.
- Credit conditions have improved and defaults are expected to remain below average in both the high yield and leveraged loan markets.
- With wages rising and unemployment near record lows, pricing pressures appear to be building, and inflation could become a greater threat to portfolios over the next few years than it was in the previous decade.
COLLISION COURSE: INFLATION AND THE RETIREMENT GLIDEPATH
With wages rising and unemployment near record lows, pricing pressures appear to be building, and inflation could become a greater threat to portfolios over the next few years than it was in the previous decade. Rising inflation presents a particular challenge to participants in defined contribution plans who are retired or nearing retirement. Typically, at this point, they are expected to allocate a larger share of their portfolio to fixed income to reduce their risk levels. For portfolios invested in lifecycle or target date funds, the fixed income allocations are typically increased as the target date approaches. But often these holdings consist only of government securities and high grade corporate bonds, which offer little or no protection against inflation.
Portfolios that are heavy with bonds are also more vulnerable to interest rate risk. Given the current environment, with inflation is rising and the Federal Reserve is raising interest rates, more retirees and near-retirees are shifting into an asset class that appears likely to face headwinds over the near term.
To hedge against inflation and reduce interest rate risk, investors would be wise to consider a multi-pronged approach. In addition to making use of one or more traditional inflation protections, which have some drawbacks, investors should consider complementing these with high yield bonds and floating rate loans, also known as leveraged loans or bank loans. Both have performed well as hedges against inflation over the past two decades, and they are less encumbered by interest rate risk and other drawbacks that hurt the effectiveness of more traditional hedges.