A bond is a fixed-income security. Bonds allow governments and companies to sell some of their debt to investors. Bonds that offer a fixed interest rate are exposed to interest rate risk. If you buy bonds, it's best to know how interest rates could affect your investment.
Inflation is the rising level of prices for goods and services. It can have two negative impacts on those who invest in bonds. One is obvious, while the other is more subtle. To invest wisely, you should learn about both.
In short, inflation makes interest rates go up. This in turn makes bond values go down. But the full picture is more complex.
Bond interest rates are also called "bond coupons." A bond with a fixed coupon rate will hold the same interest rate, no matter what happens in the market.
What Is Inflation?
Inflation is the rise of prices for goods and services across all sectors in an economy. The effect of inflation is to decrease the value of money. When inflation rises, you are able to buy less with your money.
Inflation is measured using the Consumer Price Index (CPI). The CPI tracks the change over time in the price of goods and services.
Inflation and Federal Reserve Policy
The Federal Reserve (the Fed) is the United States' central bank. It sets the country's monetary policy and manages inflation. When inflation rises, the Fed may choose to raise short-term interest rates. The goal is to reduce the demand for credit and help prevent the economy from overheating.
When the Fed raises short-term rates—or when it is expected to do so in the future—intermediate and longer-term rates also tend to go up. Since bond prices and yields move in opposite directions, rising yields mean falling prices. This means a lower value for your fixed-income investment.
Nominal Returns vs. Real Returns
The second impact of inflation is less obvious. But, it can take a major bite out of your portfolio returns. This effect is the difference between the “nominal” return and the "real" return. The nominal return is what a bond or bond fund provides on paper. The real return is adjusted for inflation.
Nominal Return - Inflation = Real Return
To understand this concept, think of a shopping cart of food that you buy at the supermarket. If the items in the cart cost $100 this year, inflation of 3% means that the same group of items cost $103 a year later.
Let's say that during that same year, you have a short-term bond fund with a yield of 1%. Over the year, the value of a $100 investment rises to $101 before taxes. On paper, you made 1%. But in real-world money, they actually lost $2 worth of purchasing power. The “real” return was –2%.
The average rate of inflation in the United States since 1913 has been 3.2%. This is skewed somewhat by the high-inflation periods of World War I, World War II, and the 1970s. But, it still means that investors needed to earn an average annual return of 3.2% just to stay even with inflation. However, with the pandemics' impact, the annual inflation rate for the United States jumped to 5.4% for the 12 months ended June 2021. This rate has not occurred since 1932. Hence, all eyes are on the next inflation update scheduled for release on in the summer of 2021 to see whether this inflation state is only transitory.
Keep in mind that inflation compounds each year, just like investment returns. But with inflation, the result is negative. From 1982 through the present, inflation has risen nearly 100% on a cumulative basis due to this compounding effect. As a result, you would have needed to see the value of your investments double during that time just to keep up with inflation.
Real Returns vs. Safety
In some cases, investors are willing to trade a negative real return in exchange for safety. You may decide that preserving your principal is more important.
If safety isn’t your top priority, be mindful of the impact of inflation. If your goal is to build a nest egg for the future, a bond or bond fund that pays 2% isn’t going to cut it. (Remember, your total return should be over 3.2%.)
Instead, consider a diversified approach. Add medium- to higher-risk investments such as investment-grade corporate bonds, high-yield bonds, and equities.
Also, many mutual fund companies offer real return funds designed to stay ahead of gradual inflation. One drawback to these bond funds is that their costs tend to be high. Both Vanguard and Fidelity offer products with lower fees than the industry average.
The Bottom Line
Inflation will always be a silent thief eating away at the value of your long-term investments. With some planning, you will be able to stay a step ahead of it.
The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.