Question

Inflation has remained low for the past 5 years but you have come to the conclusion that trend is ending and inflation will increase significantly over the next 2 years. Assume you have reached this conclusion prior to other investors reaching the same conclusion. What adjustments should you make to your bond portfolio in light of your conclusions?

Answer 1

Bonds are considered to be a safe investment class for an investor. It pays a fixed interest periodically and the principal amount is generally expected to be safely returned by the issuer at the maturity of the bond. However, it is very crucial for investors to understand the risks associated with fixed-income investments. The inflation is one of the major threats to bond investments and are explained as follows:

1. Impact on inflation on capital investment:

• When inflation goes very high, Central banks raise interest rates to reduce the money supply and reduce inflation. The interest rates in the economy act as benchmark for the yields the bonds should generate given their risk profiles
• As the benchmark interest rates go up and down in the economy, the market prices of bonds also move up and down, adjusting their yields according the interest rates
  • When interest rates go up, the bond prices must go down to adjust their yields to the new higher level of benchmark interest rates and vice-versa
• Higher inflation, therefore, offers a substantial risks to the market value of bonds and if the investor is forced to redeem his investment before the maturity date, he may have to take a loss in his capital invested

2. Impact on inflation on interest income:

• The investors hope for a steady stream of interest income while investing in a fixed-income security. However, inflation can negatively impact their returns by reducing the value of money, so much so, that the real returns could even become lower or negative.
• For example- If a bond provides 3% p.a. interest and inflation is 4% p.a., the real return of the investor (real return) is negative 1% p.a.

3. Required changes in bond portfolio

• If an investor has concluded that the inflation is set to go substantially higher over the next couple of years, it's very likely that the Central bank will raise the short-term and medium-term interest rates in the economy, along with some impact on long-term interest rates as well.
• Once the interest rates go up, the market values of his bond portfolio will go down substantially
• It is therefore a good time to redeem his bond investments at the current levels and to re-enter the bond market at much cheaper levels, once the market prices of bonds has fully discounted the impact of higher inflation and interest rates