Investing During Inflation: What about Debt?

During past historic periods of inflation, there’s been a uniform view of debt.  Holding bonds is bad, as high inflation meant rising interest rates and a declining value for fixed income investments.  In addition, the traditional belief is that being in debt is good as the value of the debt lessens due to inflation.  However, this particular inflationary cycle that I believe we are entering into appears different.  As indicated in a previous post of inflation and real estate investing, I think that additional factors have to be considered and that this is not a traditional inflation cycle.  Let’s look more closely:

Investing in traditional (fixed coupon) bonds: although I believe that inflation will be negative for US Treasury bonds, this next cycle of inflation may prove positive for high yield bonds, particular for corporate high yield debt and emerging market debt.  As growth and inflation improves earnings of corporations and the high growth economies of the emerging markets, both of these asset classes should benefit.  Unfortunately, both of these have performed extremely well in the first half of 2009 and may not have much more room to rise.

Foreign currency denominated bonds: Foreign currency bonds are expected to outperform US$ denominted bonds due to the potential decline in the US dollar as well as greater fiscal prudence of major economies outside of the US.  In the previous major cycle of inflation (1970’s), foreign currency bonds weren’t as easy to invest in as they are today.

Investing in TIPS: Inflation-indexed bonds (TIPS) are expected to perform well in a cycle of inflation, as the principal is indexed to inflation.  TIPS are also a great hedge as the principal value has a minimum value even in the face of deflation. One wildcard has been that we have not observed how TIPS perform during high inflation times, since they have not been regularly issued.  It will be interesting to observe the supply an demand dynamics as the news increasingly reports on inflation.

Having debt: historically inflationary periods were a good time to be a debtor.  As inflation escalated, given that debt payments tended to be fixed, this was thought of as positive.  However, the gain for debtors usually came with incomes rising.  Without income growth, being a debtor is problematic in an inflationary environment.

See more inflation musings in previous posts:
Investing for Inflation
The Money Illusion
Will Historic Patterns Hold
Rampant Inflation: My Big Early Retirement Worry
Real Estate