Understand how inflation affects the real yield of bonds
What is inflation?
Inflation is the rise in the price level of goods and services. Inflation can have two negative effects on bond investors. The first is obvious, while the second is less noticeable. To invest wisely, you need to learn about both.
Inflation and Federal Reserve Policy?
The Federal Reserve is the central bank of the United States. It sets the country’s monetary policy and manages inflation. When inflation rises, the Federal Reserve may choose to raise short-term interest rates. The goal is to reduce demand for credit and help prevent the economy from overheating.
Nominal yields vs. real yields
The second effect of inflation is less obvious. But it can significantly affect your portfolio’s returns. This effect is the difference between “nominal” yield and “real” yield. The nominal yield is what a bond or bond fund yields on paper. The real yield is the yield adjusted for inflation.
To understand this concept, think of a shopping cart you purchase from the supermarket. If the items in the cart cost $100 this year, a 3% inflation means the same set of items will cost $103 after one year.
Suppose during the same year, you have a short-term bond fund with a yield of 1%. Over the year, the value of the investment rises from $100 to $101 before taxes. On paper, you made 1%, but in reality, you lost $2 in purchasing power. The real yield was -2%.
The average inflation rate in the United States since 1913 has been 3.2%. It is somewhat distorted by periods of high inflation during the two World Wars and the 1970s, but it still means that investors needed to earn an average annual return of 3.2% just to break even with inflation. However, with the pandemic effect, the annual inflation rate in the United States rose to 8.2% for the 12 months ending in September 2022.
Remember that inflation compounds annually, just like investment returns. But with inflation, the outcome is negative. From 1982 to the present, inflation has risen by nearly 100% on a cumulative basis due to this compounding effect. Thus, you had to see the value of your investments double during that time just to keep up with inflation.
Real yield vs. safety
In some cases, investors may be willing to exchange a negative real yield for safety. You may decide that preserving your capital is more important.
If safety is not your top priority, be wary of the effects of inflation. If your goal is to build a nest egg for the future, a bond or bond fund yielding 2% will not be sufficient. (Remember that your total yield needs to exceed 3.2%.)
Instead, consider a diversified approach. Add medium to high-risk investments such as investment-grade corporate bonds, high-yield bonds, and stocks.
Many mutual fund companies offer real yield funds designed to keep ahead of gradual inflation. One downside to these bond funds is that their costs can be high. Both Vanguard and Fidelity offer products with below-average industry fees.
Conclusion
Inflation will always be a thief that eats into the value of your investments in the long run. With proper planning, you can stay one step ahead of it.
Frequently Asked Questions (FAQs)
How can you hedge against inflation?
To hedge or protect yourself from inflation, choose investment tools likely to outperform inflation. For example, Treasury Inflation-Protected Securities (TIPS) are a type of bond that adjusts the principal value of the bond based on inflation. Stocks usually keep pace with inflation but are more volatile. Real estate is another investment that typically keeps up with inflation. A good financial advisor can help you devise a strategy that meets your needs.
Do
Are savings bonds a good investment?
Savings bonds typically have interest rates that align with the rates of other secure savings vehicles like bank savings accounts. This means that the interest rate is relatively low, but the initial risk level is also low. They are a good investment if your goal is to preserve your capital. Other options such as certificates of deposit or fixed-rate annuities can also meet this goal and may offer a higher interest rate. If your goal is growth, there may be other investment vehicles that are better suited for that.
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Sources:
The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts in our articles. Read our editorial process to learn more about how we fact-check and keep our content accurate, reliable, and trustworthy.
Congressional Research Service. “Introduction to the American Economy: Inflation.”
U.S. Bureau of Labor Statistics. “Consumer Price Index.”
Federal Reserve Board. “Purpose and Functions of the Federal Reserve System.”
Federal Reserve Bank of Minneapolis. “Consumer Price Index, 1913-.”
Source: https://www.thebalancemoney.com/the-impact-of-inflation-on-bonds-417071
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