Effect of Inflation on Bonds Part 2

Effect of Inflation on Bonds

While inflation has hardly taken center stage among our economic woes of late, there are some credible voices in economics who are already warning of its dangers down the road. Since the FED has already locked itself into rock-bottom interest rates for the foreseeable future, if the economy does not surprise us with a great rebound in the next few years the Fed will have to resort to its one remaining tool, i.e. an expansionary monetary policy, adopting more aggressive quantitative easing, debt monetizing, and other stimulating (but also inflationary) measures. In short, the FED will have to print more money.

At that time, the threat of inflation will be real once more. It’s advisable to reacquaint ourselves in advance with the basic effects of inflation so that when it comes, we’re prepared to deal with the consequences. Today we’ll be looking at how this would affect the bond market specifically. The following are some things you should know about the effect of inflation on bonds:

The Problem with Inflation

Effect of Inflation on BondsAs we saw in a previous article Impact of Inflation on Bonds Part 1, the main problem with bonds in an inflationary environment (more so than stocks, which would tend to adapt) is that a discrepancy begins to open up between the rate of return on bonds and the rate of inflation. So for instance, if your bonds are yielding 2% for the year, but prices are inflating at 3.5%, your statements would still show a supposed gain of 2%, but this would represent an actual loss in terms of purchasing power.

Another risk is that if serious inflation were unleashed, the Fed would have no choice but to try to counteract it by raising interest rates, after years of driving them down. The result of this would be rising bond yields in tandem with falling bond prices, the end result of which is a loss of principal value for current bondholders.

It remains to be seen whether inflation will rear its ugly head and join our other major economic problems in this decade, but it’s certainly one possible side-effect on the way out of this recession. Just keep in mind that bonds, despite their many virtues as safe and stable investments, are sensitive to the effects of inflation should it break out in a bad way.

During highly inflationary times, the best solution is a sensibly diversified portfolio that embraces a variety of investments including Precious Metals including Gold. The Stock Market tends to do well in times of economic growth and moderate inflation. Investment institutions also offer products specifically designed to thwart inflation, such as “real return” funds, while governments offer inflation indexed Bonds which may also be worth considering as they adjust their return based on the official inflation rate. Bonds (both Corporate and Government) do well during times of low inflation and falling interest rates.

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About the Author:

A freelance blogger with a strong work ethic, Angelita Williams lives for scooping the next big story. Among her preferred topics of writing are online learning, distance courses, and the growing trend of mobile education. If you have any comments or questions, you can reach Angelita at angelita.williams7@gmail.com

 

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