Loading the player...

What is 'Inflationary Risk'

Inflationary risk is the uncertainty over the future real value (after inflation) of an investment.

BREAKING DOWN 'Inflationary Risk'

Inflationary risk refers to the the risk that inflation will undermine the performance of an investment. Looking at results without taking into account inflation is the nominal return. The value an investor should worry about is the purchasing power, referred to as the real return.

Bonds are the one investment that is most vulnerable to inflationary risk. In fact, just as a moth can ruin a great wool sweater, inflation can destroy the net worth of a bond investor. And far too often, once a bond investor notices the problem with their investment, it is too late. Most bonds receive a fixed coupon rate that doesn't increase. Therefore, if an investor buys a 30-year bond that pays a 4 percent interest rate, but inflation skyrockets to 12 percent, the investor is in serious trouble. With each passing year, the bond holder loses more and more purchasing power, regardless of how safe they feel the investment is.

As an example of this inflationary risk with bonds, consider an investor with $1,000,000 bond investment with a 10 percent coupon. This might generate enough interest payments for a retiree to live on, but with an annual 3 percent inflation rate, every $1,000 produced by the portfolio will only be worth $970 next year and about $940 the year after that. Rising inflation means that the interest payments have progressively less purchasing power, and the principal, when it is repaid after several years, will buy substantially less than it did when the investor first purchased the bonds.

Counteracting Inflationary Risk

Some securities attempt to address inflationary risk by adjusting their cash flows for inflation to prevent changes in purchasing power. Treasury Inflation Protected Securities (TIPS) are perhaps the most popular of these securities. They adjust their coupon and principal payments for changes in the consumer price index, thereby giving the investor a guaranteed real return.

Some securities provide inflationary risk protection without attempting to do so. For example, variable-rate securities provide some protection because their cash flows to the holder (interest payments, dividends, etc.) are based on indices such as the prime rate that are directly or indirectly affected by inflation rates. Convertible bonds also offer some protection because they sometimes trade like bonds and sometimes trade like stocks. Their correlation with stock prices, which are affected by changes in inflation, means convertible bonds provide a little inflation protection.

RELATED TERMS
  1. Inflation Protected

    Inflation protected refers to types of investments that provide ...
  2. Index-Linked Bond

    An index-linked bond is a bond in which payment of income on ...
  3. Treasury Inflation Protected Securities ...

    Treasury inflation protected securities are securities that are ...
  4. Rate Level Risk

    Rate level risk refers to the fact that the value of an existing ...
  5. Long Bond

    The long bond is a 30-year U.S. Treasury Bond, the bond with ...
  6. Bond Fund

    A bond fund is a fund invested primarily in bonds and other debt ...
Related Articles
  1. Investing

    The Risks Associated with Common Investments

    Investing inherently involves some risk. Here are some of the different types of investment risks.
  2. Investing

    Understanding Interest Rates, Inflation And Bonds

    Get to know the relationships that determine a bond's price and its payout.
  3. Investing

    Six biggest bond risks

    Bonds can be a great tool to generate income, but investors need to be aware of the pitfalls and risks of holding corporate and/or government securities.
  4. Investing

    Investing in Bonds: 5 Mistakes to Avoid in Today's Market

    Investors need to understand the five mistakes involving interest rate risk, credit risk, complex bonds, markups and inflation to avoid in the bond market.
  5. Investing

    How To Choose The Right Bond For You

    Bond investing is a stable and low-risk way to diversify a portfolio. However, knowing which types of bonds are right for you is not always easy.
  6. Investing

    Why Bond Prices Fall When Interest Rates Rise

    Never invest in something you don’t understand. Bonds are no exception.
  7. Retirement

    Should I Invest in Bonds After I Retire?

    Yes, retirees should invest in bonds, but remember that not all bonds are safe investments. Seek the help of a financial advisor.
  8. Investing

    Understanding Bond Prices and Yields

    Understanding this relationship can help an investor in any market.
  9. Investing

    7 Common Bond-Buying Mistakes

    Find out how to avoid the costly mistakes made in bond portfolios everywhere. Learn to minimize the risk of suffering low or negative returns when trading.
  10. Investing

    How to Survive a Fixed-Income Bear Market

    Fixed-income bond investors need to prepare for the upcoming bear market.
RELATED FAQS
  1. What are the biggest risks of fixed-income investing?

    Learn about the three biggest risks of bonds and other fixed-income investments. Find out more about related issues and learn ... Read Answer >>
  2. Which factors most influence fixed income securities?

    Learn about the main factors that impact the price of fixed income securities, and understand the various types of risk associated ... Read Answer >>
Trading Center