Stagflation poses challenges for bond ETFs; TIPS may offer the best protection.

Stagflation is rare, but it's one of the toughest environments for a bond portfolio. When low growth and high inflation hit at the same time, it can get ugly for all bond asset classes in a hurry. In recent times, 2022 provided an example of what it can look like. The Vanguard Total Bond Market ETF (BND +0.18%) dropped by 13%. Long-term Treasuries did even worse. Even inflation-protected bonds, which should provide some protection during these environments, took a hit. With inflation expectations rising and GDP growth weakening, it's worth revisiting what these different bond ETFs might do if stagflation returns. Key takeaways - Corporate bonds come with intermediate-term durations and modest credit risk. That makes them particularly sensitive to rate increases in the same way we saw in 2022. - Treasury inflation-protected securities (TIPS) adjust principal alongside changes to inflation rates. That gives them a structural edge when inflation remains elevated for a long time. - Treasury bills could provide the best combination of income and principal protection. Their yields rise, but they can also lose real purchasing power if inflation exceeds that yield. - The longer stagflation persists, the better the chances that TIPS come out ahead. BND: The most vulnerable of the three The Vanguard Total Bond Market ETF is the broadest of the three asset classes. It tracks the performance of Treasuries, mortgage-backed securities, and investment-grade corporate bonds. That breadth is an asset in normal environments in terms of income and quality. In a rising rate stagflation scenario, however, it can be a problem. With the ETF's duration of around 5.7 years, a 100-basis-point rate increase should, in theory, result in a roughly 5.7% price decline. As inflation increases, interest rates are likely to follow. In 2022, corporate bonds held up marginally better as credit spreads remained modest. But investors shouldn't count on that being the case again. Slowing growth is likely to push spreads higher, and that will be especially damaging to lower-rated bonds. TIP: Built for the typical stagflationary environment The iShares TIPS Bond ETF (TIP +0.21%) is the only one of these three funds explicitly designed for high inflation. Principal levels adjust with inflation, which means not only does your balance increase, but interest payments can grow as well. That should work in a stagflationary environment, but it doesn't always. In 2022, the rapid increase in yields created price declines that happened faster than the inflation adjustment could keep up with. Over a multi-year stagflation period, though, those adjustments should balance out. If rate conditions change rapidly, that lag could cause problems again, but it seems less likely in 2026. SGOV: Stable principal now, but lagging eventually The iShares 0-3 Month Treasury Bond ETF (SGOV +0.03%) holds Treasury bills, which means a couple of things. First, yields on these securities tend to adjust quickly to policy. If the Fed keeps up with what's happening with inflation, this ETF's yield should rise accordingly. Second, Treasury bills have such short durations that there is minimal principal risk regardless of which way rates move. In 2022, when rates were soaring, this ETF managed to return 1.6% with almost no volatility. From a total return standpoint, that's a good thing, but the attractiveness really depends on inflation. If inflation runs higher than the yield, real purchasing power is still lost. Verdict: TIPS come out ahead For fixed-income investors positioning themselves for a potential stagflation scenario, TIPS are the best option. As we've seen, there's no guarantee they'll be able to deliver on their objective, but they have the best opportunity for success. The regular resetting of principal should help keep up with inflation and the extra interest potential could be an added benefit. Stagflation is one of the toughest environments there is for bond investors. TIPS would be the way to make it somewhat less painful.