Inflation is a deterioration in purchasing power that occurs over time. The purchasing power of money erodes with inflation, since a dollar (or any other currency) will go further today than it will at some future date. Rising inflation is a real concern for investors holding assets that produce a fixed income stream.
A bond’s stated or nominal interest rate does not take inflation into account, so investors only earn that amount when inflation is zero.
Inflation is public enemy number one
Inflation reduces the value of a bondholder’s coupon interest payments. The longer the maturity of the bond, the more pronounced the inflation effect. This is because there are many more coupon interest payments to come at further dates, which reduces the present value of those future payments even more. The principal or maturity value will also experience this reduction in purchasing power by the time the bond matures or is repaid.
Inflation also has a negative impact on fixed-income assets when it results in higher interest rates. As inflation rises, central banks will increase short-term interest rates in an effort to cool down the economy. Additionally, rising inflation expectations lead to an increase in long-term rates, which are largely determined by market activity.
The inverse relationship between interest rates and bond prices means that higher rates equal lower bond prices.
Inflation on the rise in 2021
Inflation rates in Canada and the U.S. moved higher in 2021 and eventually exceeded the target annual range of 1-3%. But, neither the Bank of Canada nor the U.S. Federal Reserve were keen to start raising rates until COVID-19 and its myriad economic effects were well behind us.
The big worry for investors is whether their return can outpace the rate at which their purchasing power is declining, amid mounting inflation. The nominal (before inflation) return needed to generate a positive real (after inflation) return, rises during inflationary periods. This is more pronounced in a low-rate environment, as investors in higher-quality government bonds could see their purchasing power diminish with fairly low inflation.
What can bond investors do?
There are some bonds that investors might consider in order to potentially limit the effect of rising inflation, which include:
Investing in bonds issued in countries with low (or lower) inflation is one way to circumvent the effect of rising domestic inflation. But, investors must realize that a foreign bond default could prove more costly than the inflation hit at home. There are also foreign exchange/currency considerations to address with global bonds.
High yield bonds
Intuitively, it makes sense to think one could stay ahead of inflation and earn a positive real rate of return by buying higher-yielding bonds. But, while boosting your yield this way might help you stay ahead of inflation, those bonds will always carry a higher risk of default.
Real return bonds (also known as inflation-protected or index-linked bonds)
Investors receive a regular coupon and a bonus payment based on the level of inflation, as indicated by the Consumer Price Index (CPI). The bond’s value will also increase based on the CPI inflation rate, which boosts coupon interest because the coupon rate is paid on the higher bond value. Most are government issued so there is no risk of default. They are longer maturities though, so more sensitive to interest rate changes. Importantly, they provide the most benefit if acquired before inflation starts rising. It’s entirely possible that the risks associated with real return bonds outweigh the risk of inflation to traditional bonds.
Forecasts are fallible
According to American economist Edgar Fiedler, “there is no such thing as a riskless hedge against inflation”. Investors must assess the various alternatives to decide whether or not those risks are worth assuming, relative to the risk of inflation to traditional bonds.
And, it need not be an all or nothing decision; investors can diversify their fixed income holdings by adding different types of bonds. They just need to avoid making considerable changes to their portfolio based on expectations.
Just because the market is calling for a certain level of inflation doesn’t mean that will happen.