While including bonds in your portfolio generally entails much less risk than purchasing stocks, there are still risks that investors need to contemplate when considering an investment in bonds. Inflation risk is nearly universal across all bonds and bond categories such as corporate, municipal and U.S. treasuries.
Causes of Inflation
Inflation is usually caused by excess demand. This means that too many people with too much money are chasing too few goods and services. Consequently, the price of everything goes up. It's textbook supply and demand economics. Sometimes, the cause of inflation derives from excessive government borrowing in the face of a weak economy and faltering government revenue. This doesn't happen often, but it's not rare either.
Inflation Destroys Value
Inflation erodes the value of money. In an inflationary environment everything costs more. If a half gallon of milk cost $2 this month and next month costs $3, inflation has cut your purchasing power 50 percent. One of the reasons to buy bonds is the reliability of future interest payments. However, inflation eats into the purchasing power of every dollar you receive from bond interest in the future. Since those interest payments are now less valuable as inflation rises, your bond is less valuable. This causes the price of the bond to drop.
Inflation Raises Interest Rates
One of the U.S. Federal Reserve Bank's core functions is to control inflation, which it does by raising or lowering interest rates. Stimulating an economy to boost economic growth and its offspring, inflation, requires lowering interest rates, which makes loans readily available to businesses and individuals to invest or spend money. Slowing down an economy that is overheated requires lowering interest rates, which is effectively a curb on inflation. It disincentivizes businesses and consumers from investing and spending money. This slows inflation. If you bought a bond in a low-interest-rate environment and interest rates are rising, the investors who are buying new bonds are getting a better interest rate, or yield, which makes your bond less valuable. If you buy a bond in a high-interest-rate environment and interest rates are dropping, your bond is paying a higher rate of interest than most of the bonds currently available for sale. This makes it more valuable. This is known as the inverse relationship between bond price and bond yield.
Governments often offer bonds with inflation protection. For example, you can buy U.S. Treasury Inflation-Protected Securities, also known as TIPS. The principal value, or par value, of these securities is adjusted according to the Consumer Price Index, which is the government's measure of inflation. This adjustment ensures your investment protects you against inflation but usually comes at a cost of the coupon value, or interest rate, of the bond, meaning your interest rate will be lower than a traditional U.S. Treasury bond.
- maximum inflation image by John Sfondilias from Fotolia.com