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For most investors, at least part of their portfolio is allocated to bonds, and for a good reason. Bonds provide income and stability, typically carry less risk than stocks, and add balance and diversification to portfolios.
While this diversification benefit is crucial, it’s important for investors to understand how external factors, especially inflation, influence bond prices and overall portfolio performance.
What is a bond, and how does it work?
Before jumping into how inflation impacts bonds, it helps to first understand how bonds work.
Bonds are an agreement between an investor and a bond issuer — typically, a company or government — that works like a loan. The investor lends a company or government money by purchasing a bond. The issuer pays the investor interest over a specific period of time, then repays the principal when the term ends.
There are two main types of bond interest payments.
- Fixed rate: The interest rate is set when the bond is listed and stays constant throughout the bond’s life.
- Floating rate: The interest payment increases or decreases depending on current interest rates.
How inflation impacts bonds
When inflation rises, interest rates usually follow as the Federal Reserve tightens monetary policy to control the rise in prices across the economy. Inflation and the higher interest rates that follow impact bonds in a few ways.
Inflation erodes bond returns
Because bonds are often long-term investments, high or stubborn inflation erodes the value of future bond payments that investors receive and the principal received upon the bond’s maturity.
Here’s an example. Say you buy a 10-year bond for $1,000 that has a 5 percent fixed interest rate. The Fed targets a 2 percent inflation rate for a healthy economy, and inflation was three and four times that through much of 2022 and 2023.
Over the 10 years you hold that bond, inflation will fluctuate and may outpace your interest payments and the $1,000 you get back will have less purchasing power than a decade ago. Even a lower rate of inflation, such as the current 2.9 percent, can cut into your returns on a long-term bond.
On the other hand, some bonds can actually be a hedge against inflation because their interest rates rise and fall with inflation. These include:
- Bonds with floating rates.
- TIPS, or Treasury inflation-protected securities from the U.S. government.
- Series I bonds, a Treasury bond that paid a record-breaking 9.62 percent interest in 2022 when inflation spiked.
Inflation makes bond prices fall
Inflation can drive bond prices lower. This is because rising interest rates make existing bonds less attractive to investors than new bonds issued at higher rates. In other words, investors are less likely to buy older bonds that yield less. They’re more likely to buy new bonds with better yields. The reverse happens when the Fed cuts rates and inflation begins to decline.
Think of it like buying a used car. Say you go to buy a car made in 2022 that’s $30,000 and gets 20 mpg. That car becomes less valuable, though, if there’s a 2024 model for the same price that gets 40 mpg.
This mirrors how bonds work. When new bonds pay higher interest rates because inflation is up, older bonds that pay less start to look less attractive.
How to invest in bonds when inflation is a factor
Understanding the relationship between bonds and inflation can help you balance your portfolio when inflation is stubborn or high and prepare for future shifts in inflation.
- Focus on shorter-duration bonds: Short-term bonds are less sensitive to interest rate changes than long-term bonds.
- Consider TIPS or floating-rate bonds: TIPS and floating-rate bonds serve as a protection against inflation by adjusting their interest rate based on inflation.
- Diversify across different bond types: The best way to protect your bond investments from inflation is to diversify your bond holdings across different types and maturities. For example, owning government bonds, corporate bonds and municipal bonds all with different maturities.
- Buy a bond fund: Investing in a bond fund offers instant diversification, more liquidity than owning individual bonds, professional management and a lower minimum investment. There are many different types of bond funds designed to meet different goals, such as investing for retirement, short-term returns or higher yields.
Bottom line
Understanding how inflation impacts bonds can help you better allocate your assets within your portfolio and maximize your returns. You can build a bond portfolio that hedges against inflation by diversifying your investments and holding different types of bonds with different maturities. A bond fund will automatically manage those factors for you.
Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past investment product performance is no guarantee of future price appreciation.
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