How Does Inflation Affect Bond Prices

One of the most important economic factors affecting financial markets is inflation, which refers to a gradual increase in general price levels over time. Where its impact is particularly felt, however, is in bonds. As fixed-income instruments, bonds are sensitive to inflation changes and the complex relationship between them is an important factor for investors as they encounter game afterward.

The Basics of Bonds

To understand the effect of inflation, we must first have a basic understanding about bonds. Essentially, a bond is an investor's loan to a borrower--a government or corporation. To receive this loan, the issuer agrees to pay periodically coupon payments (interest) and return of principal at maturity. A bond's interest rate, or coupon rate is set at issuance.

Inverse Relationship: Bond Prices and Interest Rates

Prevailing interest rates are inversely related to the price of a bond. If interest rates go up, the value of existing bonds will fall. Whereas if they come down again well everyone's hearts are happy; bond prices tend to rise. The reason is that higher interest rates tend to make the fixed coupon payments on existing bonds less attractive in comparison with newly issued-bonds which offer much higher yields.

Inflation's Impact on Interest Rates

Inflation is an important factor influencing interest rates. Therefore, central banks generally alter interest rates to combat inflation. When inflation is rising, central banks may raise interest rates to slow down economic activity and prevent prices running wild. In fact, in times of low inflation or deflationary pressure central banks will cut interest rates to stimulate economic growth.

Real vs. Nominal Returns

Besides nominal profits, investors want real returns-that is to say, ones that allow for inflation. With inflation factored in, the true return on an investment is simply its nominal rate of return minus interest-rate. Bond holders' ability to buy future interest and principal payments might be weakened by fluctuation of inflation.

Inflation's Effect on Bond Prices

Bond prices are affected by inflation which changes interest rates. With prices rising, central banks often raise interest rates to combat inflation. Higher interest rates reduce the present value of future cash flows from bonds, so bond prices fall. Especially for current bonds with fixed coupon rates, which are less attractive as they generate smaller returns than the higher yields on the market.

Types of bonds and inflation protection

Inflation's ill effects could be avoided by certain types of bonds. Conventional fixed-rate bonds, they are not. Treasury Inflation-Protected Securities (TIPS) are in fact tailored to protect investors from inflation. The principal amount of TIPS adjusts with changes in the Consumer Price Index (CPI) so investors receive a real return that reflects their actual purchasing power.

Bond Investment Strategies in Inflationary Eras

With inflation on the rise, investors planning for bond returns must take measures to prevent damage to their portfolios. Diversification, such as exposure to inflation-protected securities, is one way of doing this. Furthermore, the constant supervision of economic indicators and central bank policies also means that investors can make choices based on changes in market conditions.

Conclusion

Ultimately, the relationship between inflation and bond prices is complex. But investors need to be aware of the impact inflation could have on interest rates, and how this would affect bond prices. But whether by incorporating inflation-protected securities strategically in their portfolios or through active portfolio management, recognizing the forces at work is vital to investors on that constantly shifting financial landscape. With inflation a primary economic indicator, soon-to-be bond investors who hope to safeguard and expand their holdings over the long term will need all they can get.