Bonds are generally considered a defensive investment and a safe haven when markets trend down or become volatile. Yet, it’s important to remember that bonds aren’t immune to economic forces. Specifically, inflation can decimate the returns bonds offer through coupon payments. Investors looking at diversifying into bonds need to be aware of bonds’ inflation risk and strategies for offsetting it.
Inflation risk can be a tricky concept to understand because it’s impacted by two diverse factors: bond interest rates and current inflation rates. Depending on the bond you hold and the macroeconomic forces affecting inflation, your bond portfolio could face more or less inflation risk than someone else’s.
Here’s a closer look at bonds’ inflation risk: the concept, how to measure it and strategies for mitigating risk over time as you build a healthy bond portfolio.
What is Inflation Risk?
Inflation risk is the amount of your investment yield that’s eroded by inflation over time. It’s measured by subtracting the annual inflation rate from the annual yield of the investment, to arrive at the real rate of return. Investors can apply this calculation in both forward-looking and retrospective capacities, to anticipate real rate of return before investing or to calculate the efficacy of an investment after exiting the position.
Inflationary Risk Example
Stephanie holds a five-year $10,000 bond with a 10% coupon rate. The annual inflation rate is 3%. Stephanie’s bond has a diminishing rate of return year over year due to inflation risk. After year one, her $1,000 coupon payment is akin to $970. In year two, the $1,000 has a value akin to $940. This loss of value continues through the bond’s term.
How Inflation Affects Debts vs. Equities
Inflation risk affects all investments, because it’s always working against value appreciation. However, it disproportionately affects debt assets more than equities. This is because the value of bonds remains fixed over the term, whereas equities fluctuate in value and have the potential to appreciate more significantly to downplay inflationary concerns.
In the bond inflation risk example above, there’s nothing the investor can do to raise the value of that bond or the interest payments it yields. However, if they purchase stock in a company and that company appreciates 20% over the course of the year, the real rate of return can still outperform the market. Of course, this is a double-edged sword, since stock prices can also drop and exacerbate the losses incurred by inflation.
How to Combat a Bond’s Inflation Risk
Bonds are particularly at-risk for inflation concerns the longer the term of the bond. For instance, a 90-day Treasury Bill faces significantly less inflation risk than a 10-year Treasury Note. This is often the key to mitigating inflation risk within a bond portfolio.
Investing strategies like bond ladders and dumbbells are a great way to stagger bond terms in a way that allows investors to replace sub-par bonds as interest rates change against inflation. Consider this simple bond ladder:
- A: $10,000 at 2.1%, purchased today, maturing in year one
- B: $10,000 at 3.2%, purchased today, maturing in year two
- C: $10,000 at 3.5%, purchased today, maturing in year three
- D: $10,000 at 3.5%, purchased in year 2 using Bond A, maturing in year four
- E: $10,000 at 3.5%, purchased in year 3 using Bond B, maturing in year five
Staggering maturity dates and funding the purchase of bonds with better rates is a great way to avoid inflation risk. Cycling through bonds gives income investors the flexibility they need to adapt in the face of rising inflation rates, or to take advantage of better coupon rates.
Dumbbell strategies serve much the same purpose. The strategy involves mixing short and long-term bonds to capitalize on the high yield of long-term bonds, while using short-term bonds to avoid inflation risk. It’s a strategy that requires more active portfolio management.
A Closer Look at Treasury Inflation Protected Securities (TIPS)
For investors who want to combat bond inflation risk directly, there are always Treasury Inflation Protected Securities (TIPS). TIPS directly offset the price of inflation by adjusting their principle to match. As a result, investors will never fall behind inflation and there’s no inflation risk to consider.
The downside to TIPS? There’s no way to outperform inflation. TIPS track it to preserve wealth, not accumulate it. These inflation-proof assets are usually in a bond portfolio as a safeguard or a hedge. They come in minimum denominations of $100 and are available in 5-, 10- and 30-year maturities.
It’s worth noting that TIPS are the ultimate safe haven investment, and they typically gain favor with investors during periods of extreme inflation. The current market, in 2021 and 2022, is a great example of a time when TIPS became a popular hedge against record levels of inflation, especially alongside depressed equity markets.
Inflation is an Ever-Present Concern
Bonds can be a great hedge against market downturn and inflation, but you need to utilize them correctly. Treating some bonds as a “set it and forget it” defensive investment can end poorly if investors don’t take inflation into account. Strategies like bond laddering or investment products like TIPS are a smart way to take inflation into account.