Inflation can have a negative impact on fixed-income assets when it results in higher interest rates. Central banks, like the U.S. Federal Reserve, typically have inflation targets and, when inflation begins to exceed the desired threshold, officials will increase interest rates. Since the interest payments from existing fixed-income assets become less competitive relative to newer higher rate fixed-income instruments, prices of existing fixed-income assets will typically fall. In other words, there is an inverse relationship between interest rates and fixed-income asset prices. High inflation can also undermine the returns from strategies that rely on fixed payments.
Inflation and Interest Rates
Inflation is typically defined as a sustained increase in the price level for goods and services throughout an economy. There is no widespread consensus on the primary cause of inflation, but most economists agree that inflation typically surfaces during periods of strength in the economy when unemployment rates fall, companies must begin paying higher wages, while prices of commodities, real estate, and merchandise creep higher.
- Inflation can have a negative impact on fixed-income assets when it results in higher interest rates.
- Fixed-income instruments include bonds and certificates of deposit.
- Prices of fixed-income assets move opposite to their yields.
- Inflation typically occurs during periods of economic strength and when prices for wages, merchandise, and commodities begin to increase.
- CPI and PPI are economic indicators that are commonly used to gauge inflation.
Fixed-income assets are debt securities that deliver regular payments—sometimes called coupons—to holders until maturity. Examples include corporate bonds, government debt, municipal bonds, and certificates of deposit. For instance, a company issues a 5% corporate bond with a $1,000 face value that matures in five years. The bond pays $50 (5% of $1,000) per year for five years and then returns the $1,000 when the bond matures.
Now, suppose high inflation is driving up interest rates and, to compete with other bond issuers, the same company must now issue five-year bonds at 6%. If the investor holding the 5% bond wants to sell theirs in the market, they must now compete with the newer 6% bond. Therefore, it is unlikely they will find a buyer for their bond for the full $1,000 face value. Instead, the bond might be worth around $850, which translates into an annual yield of 6% given the $50 per year annual interest payment.
While the bondholder can always hold the bond until maturity and receive the full $1,000 face value at maturity, the hypothetical example illustrates how bond prices can fall, forcing yields higher due to the competition from similar, newer bonds. The real impact depends on the type of fixed-income instrument being held, how rapidly rates are rising, and where (short-term or long-term) rates are moving higher along the yield curve.
Understanding the difference between nominal and real interest rates can also help better understand how inflation negatively affects fixed-income assets. A bond’s nominal interest rate does not take inflation into account, and an investor will only earn that amount when inflation is zero. A bond’s real interest rate, on the other hand, indicates the investor's real return by subtracting inflation from the nominal interest rate.
For example, if the nominal interest rate is 4% and inflation is 3%, the real interest rate is 1%. If inflation is higher than the nominal interest rate, the bondholder's return is not keeping pace with the rising cost of living due to inflation. As many investors rely on bonds as a predictable source of income, periods of high inflation are undermining their returns. This is known as inflationary risk.
CPI vs. PPI
One of the most problematic aspects of inflation is that its impact on investments is not stated explicitly. Instead, investors often monitor economic indicators like Producer Price Index (PPI) and Consumer Price Index (CPI) to get a sense regarding general inflation trends.
When economists talk about rising inflation, they are usually referring to a rise in Consumer Price Index, which tracks overall prices on the retail level. Producer Price Index, on the other hand, consists of prices of consumer goods and capital goods paid to producers (mostly by retailers), and inflationary trends are reflected earlier in PPI than they are in CPI. So PPI can be useful to investors as an early signal of impending inflation.