Bonds 102: Inflation’s Impact on Bond Performance

What is inflation?

Inflation is a sustained increase in overall price levels, which results in decreased purchasing power. Most countries aim for a moderate level of inflation as it signals that the economy is healthy and growing. However, inflation can increase or decrease to undesirable levels including:

• Hyperinflation, which occurs when there is far more demand than supply. In response producers increase their prices which, in extreme cases, can lead to an upward spiral of runaway inflation.
• Disinflation describes a period of slowing inflation, which occurs when demand for goods and services begins to ease. Disinflation may occur due to slower economic growth or in response to deliberate efforts by the government to reduce inflation.
• Deflation sets in when prices fall in response to weak demand. It can lead to recession or even depression in extreme situations.

How is inflation measured?

There are several different measures of inflation. Arguably, the one most often used is the Consumer Price Index (CPI), which reflects the retail prices of goods and services including housing, transportation and healthcare.
Economists and central banks frequently reference “core inflation,” which excludes volatile parts of the economy such as food and energy as they can cause unwanted distortion to the headline inflation figure.

Other measures of inflation include the Personal Consumption Expenditures Price Index (PCE), which is preferred by the U.S. Federal Reserve because it covers a wider range of expenditures than the CPI.

What are some of the causes of inflation?

There are many factors that can contribute to inflation. One of the most visible, is rising commodity prices, which offer an example of cost-push inflation. This is where businesses pass on increasing costs to consumers.

Oil provides a great example. When oil prices increase, so too does the cost of gasoline. In turn, this increases how much it costs to produce goods and services that require transportation and producers pass on the increased gasoline costs.

Another possible driver of inflation: high employment levels, which may lead to rising wages. Increases in workers’ pay may, in the short run, cause demand for goods and services in the economy to outstrip supply, and, in response, producers raise their prices.

Currency exchange rate movements can also influence the rate of inflation. For example, as a country’s currency loses value, it becomes more expensive to buy imported goods, which puts upward pressure on prices overall.

Another type of inflation is referred to demand-pull inflation. This occurs when total demand in an economy rises too quickly and can be prompted by a central bank increasing the supply of money rapidly, without a corresponding increase in the production of goods and service. Demand outstrips supply, leading to an increase in prices.

How does inflation affect investors?

Inflation chips away at the future purchasing power of investors’ savings and investment returns. For example, an investment that returns 2% before inflation in an environment of 3% inflation will produce negative real return (i.e., the return adjusted for inflation) of -1%. Inflation can be particularly problematic for fixed income investments where the regular interest payments remain fixed until maturity. Over time, the purchasing power of these payments decline in response to inflation.

Because of this dynamic, the interest rates on bonds can be expressed as either a:

• Nominal rate which is not adjusted for inflation; or a
• Real interest rate which is the nominal rate minus the rate of inflation. For example, if a bond has a nominal interest rate of 5% and inflation is 2%, the real interest rate will be 3%.

Apart from purchasing power, inflation can influence bonds in another way. When inflation rises above a certain level, interest rates also tend to rise as central banks try to put pressure on consumers to reduce spending. In response, bond prices fall which can reduce their total return.

What can investors do to protect their purchasing power?

To maintain and grow their future purchasing power, investors need to take steps to help ensure their investments keep pace with the rate of inflation. The bond market offers a number of alternatives:

• Floating-rate notes offer coupons that rise and fall with a pre-established interest rate. Because interest rates tend to go up and down with inflation, this makes floating-rate notes positively, though imperfectly, correlated with inflation.
• Inflation-linked bonds, issued by many governments, are explicitly linked to changes in inflation. Investors have a buffer or measure of protection against inflation because both the bond’s principal and interest payments are linked to changes in CPI.
• Active fixed income managers work to deliver inflation-beating returns during inflationary environments by moving into market sectors or global regions less affected by rising prices.