How Does Inflation Affect Bond Prices?

How Does Inflation Affect Bond Prices?
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When you're trying to make a decision about investing in either stocks or bonds, you wonder which is better in times of high inflation. Stocks will grow over time and have a history of providing returns higher than the rate of inflation, but they involve some risk.

Bonds, on the other hand, are less risky than the stock market, but what is the effect of inflation on bond prices versus stocks? Here's how inflation affects bond prices.

How Do Bonds Work?

A bond is an investment that pays a fixed interest rate for a certain period of time. For example, the U.S. Treasury may issue treasury bonds that mature in 10 years and pay a fixed rate of ​3 percent.​ This rate is known as the coupon rate and will vary according to market conditions. Most bonds pay interest every six months.

There are several different types of bonds. Bonds can be issued by the federal government, state governments, local municipalities and corporations.

If you purchase a bond and hold it until maturity, you will receive the full face value that you paid for the bond. If you paid ​$10,000​ for a bond, you will receive ​$10,000​ back when it matures.

The coupon rate is the interest that a bond pays every six months until maturity. If you purchased a bond for ​$10,000​ with a coupon rate of 3 percent, you would receive interest of ​$300​ each year until the bond matures. Investors on fixed incomes like bonds because they provide a steady and reliable source of income during retirement.

However, the rate of inflation affects the prices of bonds and their real returns.

Investors like bonds for their security, but their prices and returns can be eroded by inflation.

What Is Inflation?

Inflation is the rate of increase in prices of goods and services from one year to the next for the same basket of items. For example, if you spent ​$100​ at the grocery store last year and the rate of inflation rises to ​4 percent,​ you would pay higher prices and spend ​$104​ this year for the exact same basket of goods that you bought last year. Higher inflation reduces your purchasing power.

To find the rate of inflation, the U.S. Department of Labor Statistics surveys retail prices for a selected basket of goods and services and publishes the changes each month as an index known as the Consumer Price Index (CPI). The U.S. Federal Reserve Bank monitors the CPI and other inflation indices to determine its monetary policy.

What Is the Role of the U.S. Federal Reserve Bank?

The Federal Reserve Bank raises and lowers the benchmark fed funds rate, which is the interest rate banks charge each other, in an attempt to control economic activity. If the economists at the Fed believe inflation is increasing because the economy is becoming overheated, they will raise interest rates to slow down economic growth and reduce the demand for goods and services

Consider the housing market, for example. When the central bank raises interest rates, other interest rates in the bond market also go up, such as mortgage rates. When mortgage rates increase, consumers will have to make higher mortgage payments and the demand for houses will decline. As consumers stop buying houses, the demand for things like furniture and appliances will go down.

Higher interest rates have the same effect on purchases of cars. Rising interest rates make car payments more expensive, so consumers will purchase fewer cars. This reduces the demand for new cars from automakers and, consequently, reduces the demand for the parts and supplies needed to make cars.

How Do Interest Rates Affect Bond Prices?

Here’s how interest rate changes affect bond prices. There is an inverse relationship between interest rates and bond prices. If interest rates go up, bond prices will fall. If interest rates go down, bond prices will rise. This is why.

When a bond is first issued, its coupon rate will be competitive with interest rates in the market. However, if interest rates go up, investors would only be willing to purchase this bond at a lower price in order to make the yield-to-maturity ratio competitive with the market. In other words, if a bond is issued with a coupon rate of ​3 percent​ and interest rates go up to ​4 percent,​ the bond price will fall enough to make the ​3 percent​ coupon rate competitive with the market.

The reverse is also true. When interest rates fall, the market price on an existing bond will go up enough to reduce a coupon rate to the current market rate.

Let's take an example. Suppose you buy a 10-year high-yield corporate bond that has a coupon rate of ​6 percent.​ However, four years later, you decide you want to sell the bond and use the proceeds to remodel your kitchen. Unfortunately, interest rates have gone up and new high-yield corporate bonds are now paying interest rates of ​8 percent​. Investors won't pay you as much for your bond since they can buy a new bond with a higher interest rate. Your bond’s value will go down to the point where its yield-to-maturity matches the current bond market rate.

Nominal Returns vs. Real Returns

Inflation has a negative effect on bond returns because a bond’s coupon or nominal interest rate does not account for inflation. A bond's real rate of return is found by subtracting the inflation rate from the bond's nominal interest rate. An investor would only realize the inflation-adjusted real interest rate of return, or coupon rate, if inflation were flat, which it rarely is.

Let's say you own a bond that is paying a coupon rate of ​4 percent​ and inflation is currently ​3 percent.​ Your real interest rate would only be ​1 percent​ (​4 percent​ coupon rate less ​3 percent​ inflation).

If the inflation rate were ​6 percent,​ you would actually have a negative ​2 percent​ return. When inflation is higher than the coupon rate, a bondholder’s return is not keeping up with the rising cost of living and is actually losing purchasing power.

This is the inflationary risk of investing in bonds. However, some investors might be willing to accept a negative real return in exchange for reducing the risk of their investment portfolio by investing in bonds. They may decide that protecting the principal amount of their investment is more important.