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How does inflation affect fixed income investments?

Feb 10, 2012 by Emmett from Missoula, Mt in  |  Flag
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Inflation is a risk factor that definitely affects all investments. It's especially magnified with fixed income ones. Inflation is the gradual and subtle erosion of the buying power of your dollars over time. Fixed income investments pay a steady amount of dollars of interest and return a set amount of dollars of principle at maturity. The buying power of those dollars diminish each and every year that passes. So, while you're getting the same number of dollars, you're not able to buy the same amount of goods and services with them. To help put this into perspective, your "real" return is the rate of return after the affect of inflation. For example, if the investment return is 4% and inflation is 3% then your real return is 1%. And, that's before income taxes. Fixed income investments have their place, yet you also should be realistic about your "real" return expectations, and how they may or may not help you accomplish your goals in the long run.

Comment   |  Flag   |  Feb 10, 2012 from San Diego, CA

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If you want to measure a bond's sensitivity to rising interest rates (which usually happens in higher inflationary periods), look at the bond's duration number. The longer the duration, the more sensitive the bond is. For example: If a bond mutual fund has a duration of 5.2 years, and you expect interest rates to go up by 1%, then that bond portfolio is expected to fall by 5.2%. Conversely, if interest rates were to fall by 1%, then the portfolio is expected to go up by 5.2%. This all has to do with expected cash flow from the portfolio. This is why longer maturity and lower yielding bonds have higher duration numbers.

If you hold a bond ETF or a bond mutual fund, you can fund the duration number fairly easily. But be careful. Duration isn't the only risk out there. If you buy a junk bond fund with low duration numbers, there is obviously a high level of credit risk associated with it. Do your homework first before jumping in.

Comment   |  Flag   |  Jan 06, 2015 from San Diego, CA

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Emmett even with a healthy 5% fixed income return, if we subtract 3% for inflation the "real return" is 2%. Remember, that is a return before taxes. Since we are living longer, young retirees need to consider inflation risk combined with longevity risk. A 30 year retirement period can reduce our purchasing by almost 100%!.

Stocks tend to be a better inflation hedge compared to most bonds. The real return of stocks has been 5-6%., but as we know stocks are riskier than bonds. Usually a combination of the two is recommended. There is one type of bond, Treasury Inflation Protected Securities (TIPS) that are designed to give folks some inflation hedge. In simplistic terms they pay a low coupon rate and adjust for inflation in arrears

Comment   |  Flag   |  Feb 10, 2012 from Cleveland, OH

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