How Does Inflation Affect Bonds? Everything Investors Need To Know

High inflation drags bond prices down and harms the real returns of portfolios. Learn how inflation affects bonds and the top tactics to defend against it.

by | Last updated 12 Apr, 2023 | Macroeconomics

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Understanding how inflation affects bonds is critical knowledge for fixed-income investors. As a quick recap, bonds are a type of fixed-income security that provides investors with a regular income stream. Bondholders are effectively buying debt from a government or business in exchange for regular interest payments and, eventually, the return of their principal.

Investors who buy bonds at discounted prices and hold onto them until maturity can reap some solid capital gain and interest returns. However, this strategy can be somewhat derailed by inflation. Even after collecting coupon payments and recovering the principal, wealth may still be destroyed. Don’t forget inflation erodes the purchasing power of the cash flow provided by bonds.

So, what can investors do to protect and grow their fixed-income portfolios? Let’s take a look.

How inflation affects bonds?

Bonds are, undoubtedly, one of the most popular fixed-income securities. Not only do they provide a regular stream of passive income to investors, but they are also considered one of the safest asset classes. Of course, they’re not risk-free.

Unfortunately, bonds, especially long-term ones, are sensitive to the economic cycle. Central banks like the Bank of England or the Federal Reserve typically hike interest rates when inflation rises. This is designed to slow economic activity allowing inflation to cool off.

However, as interest rates rise, bond prices drop. Why? Because new debt issues offer higher coupon rates. Therefore, investors sell their debt investments in exchange for newer, higher-yield securities of the same credit rating. This capital migration also works both ways. When interest rates drop, demand for newer bonds is typically lower due to the lower return, causing the price of older bonds to rise substantially.

When inflation rises, so do interest rates, causing bond prices to drop. And when inflation falls, so do interest rates causing bond prices to rise.

But how does stable inflation affect bonds? Central banks typically target between 1% and 3% of annual currency devaluation. This encourages consumers to spend their money and has been proven to stimulate economic growth and output.

However, while the effect on bond prices is minimal, the impact on investment can be significant. For example, let’s say an investor is holding a five-year 1% AAA bond to maturity. During this period, inflation averaged 2.5% annually. Consequently, even though the investor receives regular interest payments, the spending power of their investment is still shrinking by 1.5% each year.

What are real returns?

Nominal returns are investment returns calculated solely from current monetary values. In other words, they don’t include the effects of inflation. Whereas real returns are adjusted to include the impact of inflation. Providing an economy is not in a deflationary environment, real returns are always lower than nominal returns.

Let’s look back at the previous example. Assuming the bonds are purchased at par (meaning they were sold at no premium or discount and, therefore, no capital gains), the nominal return is equal to 1%. But after including the effects of 2.5% inflation, the investor’s real return is actually -1.5%.

How does inflation affect other fixed-income securities?

Bonds are not the only type of fixed-income instrument. And inflation has a similar impact on these alternative investments, such as fixed-income exchange-traded funds (ETFs) and certificates of deposit.

Fixed-income ETFs can be bought and sold like a stock. These funds typically contain a diverse portfolio of corporate, government, and global bonds, providing a stream of passive income through dividends. However, the price of ETF shares is ultimately tied to the underlying assets. So when the underlying bonds decline in value due to inflation, so does the ETF share price.

What about certificates of deposit or CDs? These are special bank accounts that lock investor capital away for a specified period. In exchange, they offer a slightly higher interest rate than a regular savings account.

However, if the account rate is fixed, when inflation rises, and the central bank hikes interest rates, the investor doesn’t receive any benefits, creating an opportunity cost and eroding their money’s purchasing power. But this also works in reverse. If inflation and interest rates drop, a fixed account rate can provide a higher return for the rest of the duration of the CD.

In other words, rising inflation is problematic regardless of a fixed-income security. But understanding how inflation affects bonds and other fixed-income securities creates potentially lucrative opportunities once prices begin to fall again.

Are there inflation-proof bonds?

Despite the adverse effect of inflation on regular corporate and government bonds, investors still have recourse to protect their portfolios. How? By investing in inflation-indexed bonds.

Inflation-index bonds adjust the value of the principal based on an underlying inflation index such as the Consumer Price Index (CPI). Moreover, the fixed coupon rates on these bonds are based on the adjusted principal. Therefore, regular income payments are also protected from the effects of inflation.

  • UK Index-Linked Gilts – A type of government debt. Index-linked Gilts are typically adjusted based on movements within the Retail Price Index (RPI) every six months.
  • Treasury Inflation-Protected Securities (TIPS) – Issued by the US government. Each year the par value of TIPS is adjusted based on the Consumer Price Index.
  • Series I Savings Bonds (I-Bonds) – These are government-backed bonds issued by the US Treasury. The principal value of I-Bonds is adjusted based on the Consumer Price Index every six months.

How to protect a fixed-income portfolio from inflation?

The impact of inflation on a portfolio can be significant. But as previously mentioned, investors don’t have to sit idle. Various strategies can be employed to protect and even capitalise on the effects of inflation.

  • Create Bond Ladder – This investment strategy involves investing in a collection of different bonds with different maturities. It can provide a predictable stream of passive income, reduce exposure to volatility, and mitigate the risks of rising interest rates. After all, if rates rise, a bond maturing in the near future will provide capital to buy new bonds at these higher rates.
  • Floating Rate Funds – A floating rate fund is a type of mutual fund that invests in securities with fluctuating interest rates. Therefore, if interest rates increase due to higher inflation, the fixed income received from the fund also increases.
  • Inflation-Linked Bonds – Investing in Inflation-linked bonds provides the investment safety of bonds without worrying about the impact of inflation eroding real returns.
  • Diversify – It’s generally sensible to diversify an investment portfolio across multiple asset classes, both inflation-resistant and regular.

The bottom line

Bonds provide a regular stream of income and significant security to an investment portfolio. These instruments are not risk-free.

After all, companies and even some governments can fail to keep up with scheduled payments. And in some extreme cases, such as bankruptcy, even the principal may not be repaid. In fact, this is a risk that investors in high-yield bonds have to tackle.

Nevertheless, they serve as a powerful way to diversify a portfolio. And while inflation can harm the real return generated from these instruments, investors can plan and prepare to mitigate this impact.

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This article contains general educational information only. It does not take into account the personal financial situation of the reader. Tax treatment is dependent on individual circumstances that may change in the future, and this article does not constitute any form of tax advice. Before committing to any investment decision, an investor must consider their individual financial circumstances and reach out to an independent financial adviser if necessary.

Written By

Saima Naveed

Saima spent the early days of her career advancing the finance office of a prominent manufacturing business. After taking a sabbatical, she decided to use her expert knowledge and apply it to the stock market. Now, 10 years later, she manages a substantial portfolio built using detailed and thorough analysis.

Outside The Money Cog, Saima is an avid supporter of empowering women in the workplace. She is currently working very closely with Women of Wonders Pakistan to help other women achieve their career goals.

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Edited & Fact Checked By
Zaven Boyrazian MSc

Zaven has worked in several industries throughout his career, from aircraft factories to game development studios. He has been actively investing in the stock market for the better part of a decade, managing over $1 million across multiple portfolios.

Specializing in corporate valuation, Zaven employs a modern take on the principles set out by Benjamin Graham to find new opportunities at fair prices.

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