A look at ETFs to help investors protect against inflation

Karen Schenone, Head of iShares Fixed Income Strategy for USWA within BlackRock's Global Fixed Income Group, joins Yahoo Finance to discuss ways investors can protect their portfolio against inflation.

Video transcript

ALEXIS CHRISTOFOROUS: I want to make a hard turn now because it is time for our ETF report, brought to you by Invesco QQQ. I want to welcome in Karen Schenone. She is Head of iShares Fixed Income Strategy for USWA within BlackRock's Global Fixed Income Group. So we have our eye here on the bond market, Karen. Thanks so much for being with us. I want to talk to you about sort of, well, the theme of our discussion is how investors can protect their portfolio from inflation risks. And I'm wondering how much of a risk inflation still is.

I mean, we got that Consumer Price Index Report yesterday. It showed that inflation, while elevated, hasn't really risen much over the past month. It's-- is it really transitory the way the Fed has been setting us up for? And do investors need to get defensive when it comes to inflation?

KAREN SCHENONE: Yes, we think investors should definitely be protecting their portfolios against inflation as you mentioned the consumer price index has been up about 5.2% year over year. And it's been trending upwards for the past six months. A couple of the drivers of that, we see the economy reopening. There's definitely some transitory factors. We're seeing increases in energy prices, vacation, leisure, used cars. A lot of different price points are increasing.

And also the US Federal Reserve is pursuing more of an aggressive inflation targeting policy, where they're letting that drift up a little bit. So we think investors are generally, from a portfolio construction standpoint, underweight inflation fighters. So people are starting to use bond ETFs as a way to very specifically target sectors of the market that will protect against inflation. Probably the biggest one in the bond market is the TIPS market, the Treasury Inflation Protection Securities. So these are bonds that actually will increase in value with those consumer price index increases. And we've seen TIPS actually outperform nominal Treasury bonds by almost 5% this year, which is actually in line with inflation.

Additionally, we're seeing other sectors like high yield-- the high yield market tends to protect against inflation, just because it has higher income levels. Our iShares Fallen Angels ETF, FALN, has actually been one of the best performers this year. It has high sector exposure to both energy and some consumer cyclicals, which are going to do better as the economy is reopening.

And then, finally, convertible bonds, it's-- these are bonds that actually convert over to stocks. And the interesting thing about it is, when you have inflation, equities actually do a really good job of protecting against inflation. And convertible bonds have a very high correlation to the stock market. So between inflation protection securities, between TIPS, Fallen Angels, and convertible bonds, those are just some of the ideas we're seeing investors implement under this environment.

ALEXIS CHRISTOFOROUS: What about-- since this is our ETF report, I know you're also talking about leveraging fixed income ETFs as inflation hedges. Talk to us more about that strategy.

KAREN SCHENONE: Yeah, so with fixed income ETFs, we're just simply holding bonds. They're very low cost solutions. So, for example, TIP, that's our flagship TIPS ETF. We also have a shorter maturity version, STIP, that's been very popular this year. Both of those tickers within Fallen Angels, FALN, is the fund that we would recommend.

Additionally, we see with convertible bonds-- our ticker there is ICVT. And so we're just seeing more and more interest with inflation-protected bonds specifically, because investors are-- it's about 7% of the Treasury market. And we typically see most investors don't have a targeted allocation for it. So some people are putting these on for the first time. Others are just increasing their weight because they want to protect those bond portfolios against rises in inflation.

ALEXIS CHRISTOFOROUS: And I know, I was looking through your notes, and you said that at today's rate levels and inflation, the opportunity cost of holding cash is quite high. Tell us what you mean by that.

KAREN SCHENONE: Yeah, so when we take a look, with the Fed being on hold, what we tend to see right now is any sort of cash-like instrument, whether it's a bank deposit, a money market fund, or even ultra short-term bonds, just aren't yielding very much. They're yielding less than half a percent. So for a lot of us, if we're sitting in cash and we're holding something that is only yielding less than 1%, but then we've got this year over year inflation of over 5%, we call that a negative real return.

So we're seeing investors who are rethinking either that sitting in cash. We would advise sticking to a long-term plan. So get involved with stocks and bonds in this environment. Really think through your cash needs. So we do have some ultra short-term bonds ETFs. Our flagship one, ICSH, is probably the most popular way that people are at least allocating to cash-like solutions.

But otherwise, we're seeing people go to corporate bonds. Our primary fund, LQD, which is the corporate bond market, is a popular way to invest right now. We have a newer ETF, LQDB, that just holds the BBB component of the bond market. So with both of those ETFs, you're getting exposure to investment grade corporate bonds. You're at least getting yields more in the 2% range, so you're not sitting in cash with those very, very low yields. And we're seeing investors who are increasing their allocation to corporates in this environment as a way to stay invested and not just sit in cash, basically earning very little.

ALEXIS CHRISTOFOROUS: All right, Karen Schenone, Head of iShares Fixed Income Strategy for USWA, thanks so much for being with us today. We appreciate it.