Why Is Inflation Bad for Bonds?

The relationship of bonds to investing strategy always includes a long discussion of the effects of inflation on the value and strategy of bond investing. Inflation refers to the changing (usually rising) costs of buying the same equivalent package of goods and services necessary to accommodate the same standard of living. Bond investors expect a return of interest equal to the rate of inflation and the cost of borrowing.

How Bond Prices Are Computed

Bonds are priced by their maturity, coupon and credit rating. Bond holders invest monies and receive coupon income on a semiannual basis and, at maturity (or if the bonds are callable at the call date), receive their initial investment. In the meantime, bond prices vary in response to supply and demand, the general state of the economy, and the risk that inflation will increase beyond the coupon payment. In addition, continued inflation depletes the value of the maturity payment (also called the corpus or principal).

Pricing Bonds in an Inflationary Environment

Bonds have historically assumed that the true cost of borrowing is about 2.5 percent. Ignoring credit risk and maturity risk, this means that with no inflation a one-year note would trade around 2.5 percent. If inflation were to rise to 5 percent, investors would expect to receive a return of 7.5 percent to compensate them for the loss of purchasing power a year later as well as a return for the lending profit. The 7.5 percent return is called the nominal return. The real return is 2.5 percent. If a 10-year $1,000 loan is made at 8 percent while inflation is at 10 percent, the bond would decline in market value until maturity by as much as 20 percent. At maturity the bond will have decreased in purchasing power by 21.8 percent.

Inflation Affects Different Bond Sectors Differently

Inflation also affects credit risk. Some industries, such as mining, oil and real estate, benefit from the effects of inflation. The costs of exploration do not rise at the same speed as revenues. The result is greater profits and greater cash flow to pay shareholders and make principal and interest payments. Industries involved in manufacturing face rising costs that they may or may not pass on to customers, thus squeezing profit margins. In addition, customers may just forgo or substitute another item for the higher-priced item.

Bond Payments Are Fixed Payments

Like Social Security, bond payments are fixed at retirement. However, bond payments do not receive cost-of-living increases, which are really an inflation offset. Inflation that rises after the purchase of a bond means an immediate loss of market value and uncertainty about the future. The United States Treasury has issued an inflation offset called Treasury Inflation Protected Securities. The TIP bond is issued with a normal coupon and maturity but adds an amount in excess of the inflation rate (measured by the consumer price index) to the principal of the bond.

Bond Alternatives to Inflation

Recent years have seen bond investors change much of the way they invest to avoid the ravages of inflation. Many bonds are created with resettable coupon features. These are called variable rate bonds. The reset may be triggered by a regular maturity, say every month or every five years, or by a change in interest rates as measured by the CPI, the prime rate or some other measure. The result is to effectively shorten the bond maturity and average the rate of inflation over the life of the bond.

Resources

• Bonds With Inflation Hedges