How Inflation Affects Bonds

Inflation is a hot topic these days, and with good reason: food prices have risen steadily over the last few years, as has the cost of buying a home. People are worried about their futures—and no one can blame them.

Perhaps one of your retirement strategies involved investing in bonds. You were hoping for consistent, stable returns, but you may find yourself wondering: If inflation keeps rising at this rate, will my bonds even be worth anything by the time they reach maturity? Read to find your answers! 

What Is Inflation? 

Inflation is a rise in the general level of prices for goods and services in an economy over a period of time. It is commonly measured by taking the consumer price index (CPI), which measures the prices of a basket of goods and services purchased by households, and comparing it to an index from a base year. The inflation rate should always be rising – this is what signals economic growth. However, sometimes inflation rises in unfavorable ways. 

It can be triggered by a few different causes, like consumer demand outpacing the supply of goods (demand-pull inflation) or the cost of producing goods increases (cost-push inflation). 

Inflation and Interest Rates 

High-interest rates discourage spending because the cost of borrowing money has increased significantly. This typically slows

When interest rates are low, it is less expensive to borrow money, and consumers can easily increase their purchasing power. This means spending will increase, stimulating the economy.

How Are Interest Rates Determined? 

Interest rates for things like your credit card or mortgage are generally determined by the lender (aka your bank). The interest rates that banks pay, however, is determined by central banks, like the Federal Reserve.

The Fed is a financial industry regulatory authority. It was established in 1913 to foster economic prosperity and social welfare. 

Part of the mission given to the Federal Reserve is to keep prices stable, and one of the ways they stabilize the economy is through interest rates called a target interest rate. So, The U.S. Federal Reserve will choose to raise interest rates when inflation is too high, and lower interest rates when inflation is too low. 

They influence interest rates by changing the federal funds rate. The federal funds rate is the interest rate at which banks lend money to each other, and it’s one of the main tools used by the Federal Reserve to accommodate changing economic circumstances. 

Higher rates means banks are forced to pay more to shift money around, decreasing the supply available. A lower, more competitive interest rate allows banks to more freely move money around, increasing the supply and stimulating the economy. 

Bonds and Interest Rates 

Interest rates impact the bond market by influencing their market value. 

Since bonds are debt instruments, they generate interest-based returns. The higher the interest on the bond, the more attractive the investment. Therefore, when interest rates rise, new bonds will have higher coupon rates, or yields, than the existing bonds. This is because the cost of borrowing money was high at the time of issuing.

The higher interest rates of new bonds tends to attract more investors. Therefore, the price of existing bonds fall in order to stay competitive thanks to less investor demand. On the other hand, when interest rates go down, bond prices rise—which means that if you want to sell your bond before maturity, you’ll make a profit. 

How Inflation Influences Bonds

Now that you understand how interest rates (and by extension, inflation) influence bond prices, it's time to take a look at how inflation will influence bond yields.

Owning bonds guarantees you a steady income in the form of interest payments. You will be repaid the value of your initial investment, plus interest. Since bonds are fixed-income securities, the amount paid back to you, or the nominal interest, will not change.

If you were making $300 annually in interest in 2023, you would still be making $300 annually in 2050. This means that while you are still making a fixed income, the relative value of your investment will decrease, something many investors worry about. 

Inflationary Risk 

Inflationary risk is one of the primary drawbacks associated with bond investment. When inflation inevitably rises during your investment period, then the purchasing power of your fixed income payments will diminish. This can be a major problem for investors who need to use their bond income as part of their monthly expenses.

The longer the term of the bond, the higher the inflationary risk. Typically, investors look for bonds that mature within five years so that they can avoid losing too much purchasing power from inflation.

Anticipating Inflation In Your Bond Investments

When inflation hits, not only do bond yields drop, but existing bond prices drop on the market, leaving you stuck with low yields and no option to sell. Luckily, there are ways to prevent 

Understanding Real Interest  

If you're looking to make a real return on your money, you'll need to know what the real interest rate of your bond yields is.

The real interest rate of your bond yield is the interest rate minus the inflation rate.

For example, if you had a 60 year bond (which does not exist in real life) that paid you $100 in interest annually and during the observation period from 1960 to 2021, the average inflation rate was 3.8% per year. Overall, the price increase was 823.53%.

If you purchased a bond with a 50 year term in 1960 that paid you $100 in interest annually, by the time the bond matures, your purchasing power will be 1/10th of what it was in 1960.

Understanding real interest rates can help you combat interest rate risk, and help you better understand your fixed income investment.

Inflation-Linked Bonds

Normally, bonds pay a fixed interest rate until it reaches maturity, making the bond’s yield sensitive to inflation. Luckily, there are options for investors who want the stability of bond investments with the inflationary risk. They are called Inflation Linked Bonds, or ILBs. 

These securities are designed to help protect investors from the negative impact of inflation by contractually linking the bonds' principal and interest payments to a nationally recognized inflation measure like the CPI. This means that when inflation rises, the bond’s yield will too.

Even better, ILBs are issued by sovereign governments like the U.S. and the UK, so they're backed by very strong credit quality and investor protections.

Inflation-Proof Your Portfolio 

Bonds may be negatively impacted by inflation, but that doesn't mean they're a bad investment—in fact, they're one of the best ways to guarantee income in retirement. And with Hedgeful, you don't have to worry about what the right mix of bonds and inflation-linked bonds is for your portfolio; we'll handle it for you.

Hedgeful offers insightful strategy and professional portfolio management at the click of a button. We know how important it is for people to have access to a simple, holistic, and professional investment solution. Be it bonds, stocks, commodities, crypto, or any other major liquid asset class, Hedgeful can help you invest intelligently.