Fixed Income in an Inflationary Environment
If you regularly scan the front page of any financial publications, you’ve likely noticed one topic continuing to rear its head: inflation. This is not surprising given that key inflation measures such as the consumer price index (CPI) and producer price index (PPI) continue to come in at decade highs. Below, we examine some of the basic concepts that are important to understand about fixed income in an inflationary environment.
Understanding Inflation Risk
High inflation is concerning for investors and consumers alike because it reduces purchasing power – your dollar tomorrow does not go as far as your dollar today. While for consumers this may be felt more immediately as prices continue to climb at the gas station and grocery store, investors should be cognizant that expected future cash streams from investments may be worth less than when the investments were entered.
This dynamic – called inflation risk – is particularly important to understand for fixed income investors. With most fixed income products such as bonds, holders expect to receive interest payments from issuers at regular intervals, referred to as coupon payments. When the bond matures, the amount loaned to the issuer must be paid back, so holders receive the par value. Because these payments do not fluctuate with inflation rates, with the exception of Treasury Inflation-Protected Securities (TIPS), they are subject to inflation risk.
One important metric to understand is real return, which very simply can be thought of as an investment’s nominal rate of return minus the current rate of inflation. For example, a bond with a 6% coupon rate when inflation is 2% would have a real return of 4%. To get a better gauge on investment performance in an inflationary environment, one might consider using a real return metric.
Interest Rate Risk
In order to understand why interest rate risk is especially important to consider in inflationary environments, it is important to first understand the basic relationship between interest rates and inflation.
When a country’s central bank determines that inflation is running too hot, it may consider implementing a contractionary monetary policy to attempt to bring it back to target levels. One of the primary tools utilized in such a regime is the setting of the policy rate. Without getting into the mechanics of how, a central bank such as the Federal Reserve would look to raise rates to cool the economy and slow inflation. As such, in an environment where inflation is running above the Fed’s target, one could expect that it would take action to make interest rates go up.
Interest rate risk describes the inverse relationship between bond prices and interest rates: when rates rise, bond prices fall, and when interest rates fall, bond prices rise. Say you purchase a bond today whose coupon rate matches current market rates. If in the subsequent year the market interest rate has risen by one percent while the coupon is the same, then your coupon is now below market interest. If an investor could now get a new bond that would pay a higher coupon than your bond’s coupon rate, why would he pay full price for yours?
Not all bonds are subject to interest rate risk equally. Maturity and credit risk being equal, a bond with a lower coupon rate will generally have a higher interest rate risk. Additionally, a bond with a longer maturity will generally have a higher interest rate risk because the risk that interest rates will change prior to its maturity is higher.
A measure that takes both of these factors – time to maturity and coupon rate – is duration. Duration measures the sensitivity of a bond’s price to a one percent change in interest rates. As a bond’s duration increases, so does its interest rate risk.
This content is for informational purposes only and not intended to be investing advice.