Inflation can have a negative effect on fixed-income assets when it leads to higher interest rates.
It usually does. Central banks like the U.S. Federal Reserve typically set inflation targets and, when inflation exceeds the desired threshold, they raise interest rates to bring it under control.
Since the interest payments from existing fixed-income assets become less competitive relative to newer higher-rate fixed-income instruments, the prices of existing fixed-income assets in the bond market will fall. In other words, there is an inverse relationship between interest rates and fixed-income asset prices.
High inflation also undermines the returns investors get from fixed-income assets. You'll receive the same amount of cash, but it no longer buys as much as it did when you chose the investment.
Key Takeaways
- Fixed-income instruments include corporate and government bonds and bank certificates of deposit (CD).
- The prices of fixed-income assets move in the direction opposite to their yields.
- Inflation typically occurs during periods of economic strength, which forces increases in the costs of wages, merchandise, and commodities.
- The Consumer Price Index (CPI) and Producer Price Index (PPI) are economic indicators that are commonly used to measure inflation from month to month.
What Drives Inflation
Inflation is a sustained increase in the price levels of goods and services throughout an economy.
There is no unanimous consensus on the primary cause of inflation, but most economists agree that it tends to surface during periods of strength in the economy. It also can appear when there is a sudden and dramatic increase in price for a core commodity such as oil or wheat.
When unemployment rates fall, companies are forced to raise wages, leading to an increase in production costs. Those increases are passed along to the consumer in the form of higher prices for goods and services.
Inflation can occur when a country's government prints more money than is justified by the country's wealth, causing the value of the currency and its purchasing power to decrease.
Inflation and Interest Rates
Fixed-income assets are investments in the debt of a government or a company. They deliver regular payments—sometimes called coupons—to the holders of the debt until the date they reach their maturity. The initial investment is then returned.
Examples include corporate bonds, federal, state, and municipal bonds, and bank certificates of deposit (CDs).
For instance, a company may issue a 5% corporate bond with a $1,000 face value that matures in five years. This means that the bond will pay its owner $50 (5% of $1,000) per year for five years, at which time the $1,000 will be returned to the investor.
Now, suppose that during those five years inflation drives up interest rates. That adversely affects the investor in several ways:
- In the bond market, that company and all other bond issuers might now have to pay 6% in interest to find investors for their new bonds. The holder of the 5% bond will not be able to sell it at its full $1,000 face value. It might be worth around $850 (minus the amount already paid out in interest), which translates into an annual yield for its new owner of 6%.
- The bond investor's alternative is to hold onto the bond until it reaches its maturity, collecting the 5% payments and getting back the full $1,000 face value at maturity. However, inflation has reduced the real spending power of both the interest payments and the $1,000 that is returned to the investor.
- Investors talk about "opportunity cost." This is the shoulda-coulda-woulda factor. A five-year commitment to a 5% return has denied the investor the opportunity to make a better return for that $1,000.
Time Matters
The longer term of a bond, the greater the risk that inflation will hurt the investor's real return.
Fixed-income assets can be found with terms ranging from a few months to five years or more. The longest bond offered by the U.S. Treasury is a 30-year bond.
An investor in a one-year bond is taking less risk that inflation will erode its value before the bond matures.
Inflationary Risk
Understanding the difference between nominal and real interest rates illustrates how inflation harms fixed-income assets.
A bond’s nominal interest rate does not take inflation into account. A fixed-rate bond is just that. If it says 5%, the investor will be paid 5%. If that translates to $50 a month, the investor will get $50 a month every month, whether the inflation rate is up, down, or zero percent.
But if inflation has reduced spending power, that investor's $50 is worth less in the real world. As an extreme example, consider the fact that $100 in 1900 was worth the same as $3,527.10 in 2022 when the numbers are adjusted for inflation.
Real interest rate establishes the investor's actual return by subtracting inflation from the nominal interest rate. For example, if the nominal interest rate is 4% and inflation is 3%, the real interest rate is 1%.
If inflation is higher than the nominal interest rate, the bondholder's return is not keeping pace with the rising cost of living.
While many investors rely on bonds as a predictable source of income, periods of high inflation will undermine their returns. This is known as inflationary risk.
CPI vs. PPI
One of the most problematic aspects of inflation is that its impact on investments is not stated explicitly. Instead, investors monitor economic indicators like the Producer Price Index (PPI) and the Consumer Price Index (CPI) to get a sense of inflation trends.
When economists talk about inflation, they are usually referring to a rise in the Consumer Price Index, which tracks overall prices at the retail level.
The Producer Price Index tracks changes in the prices of consumer goods and capital goods paid to producers (mostly by retailers). That means that an inflationary trend will show up earlier in the PPI than in the CPI.
So the PPI can be useful to investors as an early signal of impending inflation.
Frequently Asked Questions
Why Are Interest Rates and Bond Prices Inversely Related?
Bond prices move up when interest rates fall, and vice-versa. This is because bonds that pay a fixed interest rate will become less attractive when new bonds are issued with higher yields. When those older bonds are sold, they will trade at a discount.
But if interest rates fall, newly-issued bonds will yield less. That makes the older ones more attractive. They will then trade at a premium to their face value.
Is Inflation Good or Bad for Stocks?
Stocks generally hold up better than bonds to inflation, and the effects are more varied and less automatic.
Producer price increases inevitably lead to consumer price increases but it may take time. As companies delay passing along those additional costs, their current revenues can drop, and their stock prices can drop in response.
In general, value stocks tend to perform better in high inflation periods and growth stocks perform better when inflation is low.
Which Assets Hedge Against Inflation?
Historically, real estate, gold, and other commodities have been seen as inflation hedges. Empirical work, however, reveals that these asset classes do not always live up to their reputation in this regard.
