Inflation generally refers to the rate at which prices of goods and services in an economy increase. It affects a country's economic development both positively and negatively. While excessive inflation leads to economic loss, controlled inflation is necessary for economic growth. All investors should try to understand the impact of inflation on their bond portfolio. Rising inflation occurs when the prices of goods and services keep increasing due to various reasons such as high demand, low supply, decreasing purchasing power, etc. Very high inflation is not good for the economy as purchasing power declines and people get fewer goods for the same amount of money. To stabilize the economy and get inflation back under control, economic and monetary authorities are forced to intervene.
The monetary authorities can reduce inflation by increasing interest rates and selling more bonds. New bonds will offer investors a higher coupon rate than older bonds due to the rising interest rates. The high-interest rates attract more investors to purchase the bonds. Finally, the higher interest rates encourage people to save and invest instead of spend, therefore money moves from the economy to the central bank, leading to a reduction of money supply- as a result, cooling inflation over time.
Inflation can negatively impact bond investors, as it reduces the purchasing power the bondholder would have had from the bond’s future cash flows. However, the prices of old bonds will decline to compensate new buyers for the rise in market interest rates providing an opportunity for investors to purchase bonds at lower prices, thereby benefitting from a higher return on their investment.
Investors can protect their bond investments during inflation by investing in Treasury inflation-protected securities (TIPS). Investors can also invest their money in private debt as these bonds offer higher returns and lower price risk. They can also purchase floating rate or variable rate securities- where the coupon rate will increase as interest rates rise. Investors should however, have a well-balanced portfolio with funds allocated to each investment class. Diversification of your portfolio is a good strategy to beat inflation. Finally, investing in US dollars, as this provides a hedge against devaluation as well as inflation.
Understanding the ups and downs of inflation and various other concepts is quite complex and sometimes difficult to understand. You should seek the advice of a licensed financial advisor who can help you reach your financial objectives while guiding you through the bond investment process and developing potential hedges against inflation.
Anna-Joy Tibby is the Assistant Vice-President, Personal Financial Planning at Sterling Asset Management. Sterling provides financial advice and instruments in U.S. dollars and other hard currencies to the corporate, individual and institutional investor. Visit our website at www.sterling.com.jm
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