Table of Contents
How inflation impacts bonds
How inflation affects other fixed income securities
Are there bonds that factor in inflation?
Inflation and interest rates
The bottom line
Oct 14, 2022
6 min read
Bond pricing has an inverse relationship with interest rates. When interest rates rise, bond prices usually fall. If inflation is rising, the return on a bond declines.
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.
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.
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.
Try Titan’s free Compound Interest Calculator to see how compounding could affect your investment returns.Learn More
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.
There are some bonds that factor in inflation. These include:
. 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.
. 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.
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.
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.
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.
At Titan, we are value investors: we aim to manage our portfolios with a steady focus on fundamentals and an eye on massive long-term growth potential. Investing with Titan is easy, transparent, and effective.
Get started today.
Certain information contained in here has been obtained from third-party sources. While taken from sources believed to be reliable, Titan has not independently verified such information and makes no representations about the accuracy of the information or its appropriateness for a given situation. In addition, this content may include third-party advertisements; Titan has not reviewed such advertisements and does not endorse any advertising content contained therein.
This content is provided for informational purposes only, and should not be relied upon as legal, business, investment, or tax advice. You should consult your own advisers as to those matters. References to any securities or digital assets are for illustrative purposes only and do not constitute an investment recommendation or offer to provide investment advisory services. Furthermore, this content is not directed at nor intended for use by any investors or prospective investors, and may not under any circumstances be relied upon when making a decision to invest in any strategy managed by Titan. Any investments referred to, or described are not representative of all investments in strategies managed by Titan, and there can be no assurance that the investments will be profitable or that other investments made in the future will have similar characteristics or results.
Charts and graphs provided within are for informational purposes solely and should not be relied upon when making any investment decision. Past performance is not indicative of future results. The content speaks only as of the date indicated. Any projections, estimates, forecasts, targets, prospects, and/or opinions expressed in these materials are subject to change without notice and may differ or be contrary to opinions expressed by others. Please see Titan’s Legal Page for additional important information.
You might also like
How to Calculate Annualized Inflation Rate
Determining the annual rate of inflation is a matter of finding the difference between the current number for an index such as the CPI versus its value one year earlier.
15 Positive and Negative Effects of Inflation
Inflation can be beneficial for the economy but it can affect the value of savings, income investment returns, and can lead to decrease the competition for a country.
The Highest Inflation Rate Ever
Inflation is part of the ebb and flow of the business cycle. The highest inflation in the U.S. often has been tied to wars in this country or crises in other countries.
How to Invest $25,000: 5 Ways
Investors looking to make their $25,000 grow can explore several opportunities, like CD ladders, stocks, actively managed funds, real estate, and art.
© Copyright 2024 Titan Global Capital Management USA LLC. All Rights Reserved.
Please refer to Titan's Program Brochure for important additional information. Certain investments are not suitable for all investors. Before investing, you should consider your investment objectives and any fees charged by Titan. The rate of return on investments can vary widely over time, especially for long term investments. Investment losses are possible, including the potential loss of all amounts invested, including principal. Brokerage services are provided to Titan Clients by Titan Global Technologies LLC and Apex Clearing Corporation, both registered broker-dealers and members of FINRA/SIPC. For more information, visit our disclosures page. You may check the background of these firms by visiting FINRA's BrokerCheck.
Various Registered Investment Company products (“Third Party Funds”) offered by third party fund families and investment companies are made available on the platform. Some of these Third Party Funds are offered through Titan Global Technologies LLC. Other Third Party Funds are offered to advisory clients by Titan. Before investing in such Third Party Funds you should consult the specific supplemental information available for each product. Please refer to Titan's Program Brochure for important additional information. Certain Third Party Funds that are available on Titan’s platform are interval funds. Investments in interval funds are highly speculative and subject to a lack of liquidity that is generally available in other types of investments. Actual investment return and principal value is likely to fluctuate and may depreciate in value when redeemed. Liquidity and distributions are not guaranteed, and are subject to availability at the discretion of the Third Party Fund.
The cash sweep program is made available in coordination with Apex Clearing Corporation through Titan Global Technologies LLC. Please visit www.titan.com/legal for applicable terms and conditions and important disclosures.
Cryptocurrency advisory services are provided by Titan.
Information provided by Titan Support is for informational and general educational purposes only and is not investment or financial advice.
Contact Titan at firstname.lastname@example.org. 508 LaGuardia Place NY, NY 10012.