Over time, inflation reduces the purchasing power of any currency. When investing in a corporate bond, investors must consider an essential question: how much will inflation reduce the purchasing power of the bond’s yield over time? Because of inflation, all money decreases in value over time; thus, all securities carry inflation risk. Investors must consider whether, over the life of the bond, inflation will be a significant enough factor to undermine the bond's ability to provide them their desired or needed purchasing power. When examining the returns on a bond without adjusting for inflation, this is referred to as the “nominal” return. This value is not as important to investors, however, as the “real” return, which refers to the growth or diminishing of the purchasing power a bond provides over time. This value is adjusted for inflation, as well for other external factors.
In the corporate bond world, investors choose either fixed or variable return rates that hold for the life of the bond, or as long as it is held. However, sometimes inflation or cost of living may increase so dramatically over the lifetime of a bond, especially a longer one, that the real purchasing power of the bond is diminished significantly. In extreme cases, the return rate on bonds can actually move into the negative. This is a real risk that serious investors must be aware of and account for when investing in bonds.
Due to the negative impact inflation can have on the real returns of the invested funds, corporate bond investors should consider inflation to be a highly significant risk factor that should be constantly monitored. (See also: How To Invest In Corporate Bonds.)
Impact of High Inflation Rates
Many studies have demonstrated that investor yield requirements are determined by expectations of inflation. Inflation is one of the most difficult issues for bond investors. It erodes the future purchasing power of a bond’s forthcoming cash flows. This results in a fairly reliable general correlation between yields and inflation: the higher the inflation or expected inflation, the higher yields investors will demand to compensate for this risk.
For any investment, investors must calculate real rates of return. This “real” rate is the annual rate after it has been adjusted for inflation and any other external factors. So this rate is what investors can expect to make in normal or “real” circumstances, which means it’s an accurate assessment of the corporate bond’s earning capacity.
Loss of Purchasing Power
Taking a specific example, imagine that the rate of return on a particular corporate bond is 2.5%. If there is a rise in inflation to 3.5% after an investor has purchased the bond at 2.5%, the corporate bond’s rate of real return has in fact decreased by 1%. In order to avoid a loss of purchasing power, fixed-income investors may have no choice but to head to higher-yielding corporate bonds. These securities generally exhibit higher risks although, if professionally analyzed and chosen wisely, investors may get rewarded accordingly. In the current low-interest environment, the interest in corporate high-yielding bonds (also referred to as junk bonds) has been steadily growing. Not uncommonly, first-class investment grade bonds, such as German government bonds, often do not account sufficiently for inflation.
Kang & Pflueger’s (2015) insightful study reveals that (1) the risk of inflation accounts for as much variation in credit spreads as either (2) volatility in equity or (3) the ratio of dividend to price. Comparing the credit spreads between six indexed and developed countries, a standard deviation of one in any of these three aforementioned categories can increase spreads by "14 basis points." There are two specific types of inflation risk that concern the credit spreads of corporate bonds: (1) inflation cyclicality and (2) inflation volatility. When there is a high correlation between cash flows and inflation, a risk of a low inflation recession emerges. When this happens, both cash flows and liabilities will hit firm around the same time, which increases default rates, and again, losses for investors. For this reason, investors averse to risk may lead to an increase in the premiums to account for added default risk. Second, the more volatile inflation is, the greater the probability of firms with high real liabilities defaulting.
The Bottom Line
There is a significant correlation between expectations of changes in inflation and the yields of corporate bonds. The impact of inflation risk is undisputed. Clearly, inflation risk has to be constantly taken into account when investors choose to determine their target yield and particularly the real rate of return. Otherwise, they may face a loss of purchasing power or lower returns than anticipated. (See also: High Yield Corporate Bonds: Different Structures and Types.)