What Is Inflationary Risk?
Inflationary risk is the uncertainty over the future real value (after inflation) of an investment.
- Inflationary risk is the risk that inflation will undermine an investment's returns through a decline in purchasing power.
- Bond payments are most at inflationary risk because their payouts are generally based on fixed interest rates and an increase in inflation diminishes their purchasing power.
- Several financial instruments exist to counteract inflationary risks.
Understanding 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 an 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 four 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.
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.
Example of Inflationary Risk
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.