Bonds are attractive to investors because they are generally lower risk than stocks, and pay stable, fixed interest. However, a bond’s nominal interest rate, or the stated rate of the bond or loan, doesn’t account for inflation.Inflation erodes the purchasing power of a dollar, and thereby the real return on a bond investment.

How inflation impacts bonds

Many investors choose to diversify their portfolios with bonds. Because they pay fixed interest at regular intervals–also called a coupon–over the life of the loan, bonds provide a regular income. Although bonds generally generate a lower return than stocks, they can offer stability to offset the volatility of the stock market.

On the other hand, bonds are very sensitive to economic conditions. Rising inflation erodes the value of a bond’s fixed coupon income. That’s because similar to its effect on the dollar, inflation diminishes the purchasing power of the fixed coupon payments investors receive.

During times of high inflation, the U.S. central bank also tends to raise interest rates in an attempt to fight inflation. When interest rates rise, the coupon rates of newly issued bonds also rises. In that case, investors who hold old bonds are earning less than they otherwise could if they purchased new bonds that have higher coupons. The value, or price, of the bond they hold also declines. Bond pricing has an inverse relationship with interest rates: When interest rates rise, bond prices usually fall.

Let’s say an investor bought a 10-year, $1,000 bond that pays a 3% coupon. Even if market interest rates rise to 6% in a year, the bond would still pay 3%. As such, the market value of the 3% bond will drop. Bondholders can sell their bonds, but they may have to pay a commission on the transaction, and the broker may demand a markdown. In other words, the bond may sell for a discount.

Additionally, if a bondholder’s investment reaches maturity during a time of inflation, the principal, or the original amount paid for the bond, will be worth less than it was at the time of purchase.

Real vs. nominal returns

A bond’s nominal return is the agreed-upon interest rate the bond will pay. A bond’s real return is the real value of the return on investment, both in interest payments and principal return, if inflation rises. In other words, if inflation is at 5%, investors will need to average a 5% nominal return just to break even.

How inflation affects other fixed income securities

Aside from bonds, other fixed-income instruments, such as certificates of deposit (CDs) and fixed income exchange-traded funds (ETFs), are also affected by inflation. 

CDs are bank accounts offered by banks, credit unions, and brokerage firms, and that often have penalties for early withdrawals. Similar to a bond, if the interest rate on a CD doesn’t keep up with rising interest rates, the money in a CD will lose purchasing power. Unlike bonds, the money is locked in for the term of the CD. 

Fixed-income ETFs, or bond funds that bundle various kinds of debt (corporate, government, global), can also take a hit during inflation. However, ETFs are liquid, since they are listed, bought, and sold on a stock exchange. When the market anticipates a spike in inflation, ETF holders can easily sell. On the other hand, ETF holders risk their principal more than individual bondholders; bond ETFs never mature, so there is no guarantee of fully recovering the principal. 

Are there bonds that factor in inflation?

There are some bonds that factor in inflation. These include:

• Treasury inflation-protected securities (TIPS)

  . This type of bond, issued by the U.S. government, has principal and coupon payments that are adjusted to the consumer price index (CPI), which is a gauge of inflation. This bond’s principal rises and falls with the level of inflation, which means it can offer some inflation protection, but it isn’t foolproof. If the principal value of a TIPS increases because of inflation, the gain is considered taxable income, which may offset the benefit of holding this bond. In comparison, government bonds are typically not subject to federal taxes, and municipal bond income is usually not taxed in the state in which the bond was issued.

• Series I savings bonds

  . I bonds, issued by the U.S. Treasury, earn interest based on the combination of a fixed rate and an inflation rate that’s adjusted every six months from the bond’s issue date. The bonds earn interest for 30 years (but bondholders may not cash them out before one year). They are subject to federal income tax. However, they come with aneducation tax exclusion, which allows qualified taxpayers to exclude all or part of the interest on the redemption of these bonds when they use it to pay for qualified higher education expenses.  

Inflation and interest rates

Times of high inflation tend to lead to higher interest rates, as central banks raise borrowing costs to tamp down inflation. The relationship between short- and long-term interest influences both inflation and the expectation of future inflation.

Short-term vs. long-term rates

Central banks will raise or lower short-term interest rates to respond to inflation. The U.S. Federal Reserve sets the federal funds rate, which is the interest rate at which banks can lend to each other overnight. 

Long-term interest rates, on the other hand, are a function of supply and demand on the open market. If the market believes a central bank has set the federal funds rate too low, the market will anticipate that inflation will rise in the future. And if the market believes that inflation is coming, interest rates and bond yields will rise and prices will fall as the market seeks to cover the expected loss of purchasing power. The central bank does not administer long-term interest rates, but its actions do influence them.

Typically, changes in short-term interest rates affect short-term bonds more than they do long-term bonds. Interest rates can be raised or lowered by the Fed several times without a huge effect on a long-term bond if, when the bond matures, the principal is worth essentially the same. Expectations of inflation influence the rate of return needed for an investment to break even at maturity. The higher the expected future rate of inflation, the more buyers will demand a higher yield to compensate for lower purchasing power. 

The bottom line

Bonds are relatively stable investments that investors use to collect a steady source of fixed income payments. They are used to diversify portfolios, buffering the risk of more volatile investments like stocks. But bond pricing has an inverse relationship with interest rates. When interest rates rise to make borrowing more expensive, bond prices usually fall. And if inflation is rising, the return on a bond, adjusted for inflation, declines.