The value of a bond often depends on inflation, as inflation often decreases the present value of bonds. Investors should therefore be aware of inflationary effects on bond values when managing an investment portfolio. There are many types of bonds, from high-risk to low-risk, given by governments or corporations. Researching various options can be helpful when creating a bond portfolio. The relationship between specific bonds and inflation should be known when deciding how to invest.
Inflation occurs when the general price level of goods and services increases over a period of time. As prices increase, inflation erodes purchasing power of currency. Prices can increase when economies are growing due to an increasing demand that exceeds supply, pulling prices up. Inflation can also occur due to increases in commodity or business costs as well as an increase in the supply of money.
Bonds are essentially loans and pay periodic interest based on fixed or variable rates. By purchasing a bond, investors are giving their money to a company or a government with the expectation of receiving interest payments over time. The close relationship between the value of specific bonds and inflation depends on the type of bond and should be understood before investing.
Depending on the desires of the investor, high-risk or low-risk bond options exist with various interest rates. Generally, a higher risk bond entails a higher potential payout. Higher risk can be based on the relationship between bonds and inflation, or they can also be associated with default potential or other hazards. Portfolio diversification can help safeguard against such risk.
Fixed coupon bonds represent high-risk bond investments. The return on fixed coupon bonds doesn’t change based on the interest rate. This can be excellent if deflation occurs, as national interest rates lower, but the return remains high. Inflation, however, can increase national interest rates over the fixed bond return, often rendering them less profitable or even costly.
Inflation-indexed bond markets provide a lower risk of investment, as interest rates change based on current inflation. Treasury Inflation Protected Securities (TIPS) are an example of such bonds issued by the U.S. Treasury, with an interest return linked to the Consumer Price Index (CPI). The CPI is one of the best indicators for calculating the value of bonds and inflation. While these securities are safer, ensuring that inflation does not substantially affect an investor's return, they offer a lower rate of return.
For those seeking alternate low-risk bond options, the U.S. also offers Series I Inflation-Indexed Savings (I-Bonds). I-Bonds are made up of both a fixed and variable interest rate. Income on these bonds is tax deferred, unlike with TIPS. They also provide greater flexibility in regard to changing the life of the bond.
Staying abreast of predicted inflationary percentages can help hedge investments. The Moore Inflation Predictor (MIP) is a graphical representation of potential inflationary rates. The MIP helps investors predict the value of bonds and inflation. MIP updates frequently and can be researched to provide the most updated predictors for inflation.