The goal of any investment is to earn a monetary return -- to get more money out of the investment than you put into it. Inflation works against this goal by reducing the value of the dollars you get in your returns. In periods of hyperinflation, this effect can be great enough to negate the value of a return altogether. Investors looking for stability in returns often look to bonds, but these investments might not be your best choice during periods of inflation.
Inflation is a positive change in prices over time. If you could purchase a soda for $0.50 several years ago, but now that same soda costs $0.75 cents, you have experienced inflation. Underlying these changes are changes in the money supply -- inflation is believed to be the result of too much money in an economic system. People can afford to pay more for goods and services, so producers can charge more. Extra money happens in one of two ways: either the Federal Reserve actually prints more physical money, or it lowers interest rates, making it less costly to borrow money. Often, both of these things happen in combination as part of an effort to stabilize a depression or monetary deflation. The Federal Reserve monitors both inflation and deflation carefully, adjusting interest rates and printing money as needed to keep the U.S. economy as stable as possible and avoid things like hyperinflation -- a period of extreme, rapid inflation. It's important to note that large increases in inflation aren't necessarily equivalent to hyperinflation, as economists typically see hyperinflation as a nearly complete devaluation of currency. Nonetheless, periods of great inflation are extremely difficult for consumers and investors.
Bonds and Interest Rates
When you buy a bond, you are loaning money to a company or a government entity, known as the bond issuer. In return, the bond issuer pays you interest, and that interest is your return on the bond. The bond issuer determines a rate of interest beginning with the current Federal Reserve interest rate, then adds on additional percentage points for added risk. If the chance of the company paying the bond back is very high, the interest rate will be close to that of the Federal Reserve. With riskier bonds, the interest rate will be much higher. In fixed-rate bonds, the interest remains the same throughout the life of the bond. Variable-rate bonds may adjust the interest rate for inflation or change the rate on a particular schedule.
Bonds and Inflation
The Federal Reserve's job is to try keep the rate of inflation or deflation from fluctuating too much, and they do this by moderating the amount of money in the economic system. In periods of inflation, the Reserve attempts to decrease the total money by raising interest rates. In the bond market, this means that the base interest rate is higher than it was before inflation. New bond issues have higher interest rates than the bonds already in your portfolio, making the lower interest bonds less valuable if you want to sell them. Even if you hold on to them, the rate of inflation is subtracted from your returns, because while you are getting the same amount of dollars in interest, they cannot purchase as much.
Bonds as a Safe Investment
A bond's safety in any economic climate really depends on what you, as an investor, want from your money. Bonds are traditionally more stable -- if you buy a bond from a reputable issuer, the risk of losing money is very small and you know exactly how much you'll make on the investment. On the other hand, bonds consistently return less money over time than stocks, and the risk of losing money to inflation -- hyper- or not -- is fairly high, especially if you make long-terms investments. Investors can help to mitigate this risk in several ways. Certain bonds and mutual funds are designed to combat inflation, such as the U.S. Treasury TIPS bonds. Another option is a diverse investment portfolio that includes stocks and bonds in a variety of different industries. Ultimately, your choice depends on your goals and your comfort with different types of risk.
Nola Moore is a writer and editor based in Los Angeles, Calif. She has more than 20 years of experience working in and writing about finance and small business. She has a Bachelor of Science in retail merchandising. Her clients include The Motley Fool, Proctor and Gamble and NYSE Euronext.