If you’ve been paying attention to recent business and financial headlines recently, you know that we’re living in inflationary times. The Bureau of Labor Statistics releases a monthly Consumer Price Index (CPI), an indicator of inflation. The April 2022 numbers showed that the index increased by 8.5% from the year before. In other words, people are paying 8.5% more these days for baskets of consumer goods and services.
What, then is inflation? Briefly defined, inflation focuses on either an increase in prices or a decrease in the value of money. Inflation typically reflects a high demand for limited amounts of goods or services. When this happens, prices increase.
Then how does inflation affect investments? Specifically, how are bonds affected by inflation risk? The higher the inflation risk, the higher the likely negative impact on bond investments.
Explaining Inflation Risk
Also known as purchasing power risk and inflationary risk, inflation risk focuses on the concept that inflation could impact an investment’s performance, asset value, or stream-of-income purchasing power. Moving from investment language to plain English, inflation risk means that your investment’s value could be directly correlated with the purchasing power of money. When prices go up (as is the case with inflation), purchasing power drops. Lower purchasing power could mean your investment’s value and/or rates of return decrease as well.
The takeaway here is that ignoring inflation when crafting your investment strategy could mean that you potentially end up with less than anticipated.
Inflation Risk and Bonds
Now let’s focus on bonds. While many investments can be vulnerable to inflation risks, bonds tend to have greater exposure to this issue. According to the Financial Industry Regulatory Authority (FINRA), the higher the inflation, the more likely bond yields won’t keep pace with purchasing power.
This is because bonds are fixed-income instruments. When you invest in a bond, you’re issuing debt to a borrower (typically a corporation or government). As part of the lending agreement, that entity agrees to pay you back, typically at a pre-arranged interest rate (also known as a coupon rate). By the time that bond matures, you’re owed the entire principal amount (plus the coupon rate).
So, if you’ve purchased a bond with a 5% coupon rate, that rate remains the same throughout the bond’s term. Whether inflation is at 2% or 8.5%, your bond’s interest rate will still be 5%. As a note, longer-term bonds tend to be more sensitive to inflation than their short-term counterparts. Specifically, the longer your bond’s term, the more value you could lose over time.
Understanding Bonds and Inflation
While bond investments can help balance portfolios, it’s a good idea to be aware of the pros and cons of this financial instrument. This is true, especially as they can be highly vulnerable to inflation. As such, we recommend working with your financial professional when it comes to portfolio strategy, diversification, and developing potential hedges against inflation.
