What is the Relationship Between “Inflation and Bonds”?
While some asset classes can offer some protection against high levels of inflation, fixed income is not usually one of them. Rising prices generally tend to have a negative impact on bonds as it erodes the real return achieved on the investment. In addition, when central banks raise interest rates, that can have a negative impact on bond prices too. Overall, interest rates and bond prices tend to have an inverse relationship.
Key Learning Points
- Rising inflation can have a negative impact on fixed income assets as it erodes the value of both its regular interest payments (coupons) and the initial investment (principal)
- High inflation is usually driven by a stronger economy and when commodity prices and other production costs such as salaries begin to increase
- Should a central bank’s inflation target be exceeded, there is normally a rise in the interest rate
- An interest rate increase can also have a negative impact on bond prices as their value becomes less attractive compared to the newly issued ones
Drivers and Measures of Inflation
Inflation is defined as a continuous increase in prices for goods and services in an economy. One of the possible roots of inflation could be a continuous period of strong economic growth. This may lead to a more competitive environment and lower unemployment rates. As a result, should salaries increase, that cost would be reflected in the price of the end product and transferred to consumers?
Another example of inflation that is most often observed in emerging economies is the effect of printing large amounts of money, which devalues the currency and reduces purchasing power.
There are two commonly used inflation measurements – the Consumer Price Index (CPI), which indicates the rise of consumer prices from a retail point of view, and the Producer Price Index (PPI) from the producer perspective.
Increasing interest rates is a mechanism that central banks use to combat sustained levels of high inflation. However, this can make the price of fixed income assets less attractive to the rising interest rate. For example, if an investor puts £1,000 into a corporate bond that pays a 3% coupon and has a maturity of five years. (The bond pays £30 which is 3% of £1,000, interest annually for five years, and then returns the initial investment of £1,000 when the bond matures.) Should interest rates increase, new five-year bonds will likely be issued that pay a higher coupon in order to stay competitive, for example, 4%. Those investors that hold the 3% issue will divest from the bond, but its price has already become less attractive due to the lower interest it pays, hence its price is highly likely to be less than the initial investment of £1,000.
Real vs. Nominal return
When calculating portfolio returns, investors should be aware of the negative impact that inflation has on the performance of bonds. While nominal return does not provide an accurate picture as it does not consider the rise in prices, the real return is a performance measure adjusted for inflation.
Real Return = Nominal Return – Inflation
Review the question below and see if you can get the correct answer.
Assuming BoE increases its base rate from 1.5% to 2% due to rising inflation levels, which of the below is correct regarding the price of a 1.5% corporate bond that matures in 5 years time?
- A) The price of the bond will increase as the interest rate increases too
- B) Its price will remain the same and only coupon payments will increase
- C) The bond price will decrease due to newly issued bonds offering more attractive interest rates
- D) Its price will remain the same and only coupon payments will decrease
The answer is, of course, C.