What Is Inflationary Risk?
Inflationary risk is the risk that the future real value (after inflation) of an investment, asset, or income stream will be reduced by unanticipated inflation.
- 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 risk that inflation will undermine the performance of an investment, the value of an asset, or the purchasing power of a stream of income. Looking at financial 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. Inflation is a decline in the purchasing power of money over time, and failure to anticipate a change in inflation presents a risk that the realized return on an investment or the future value of an asset will be less than the expected value.
Any asset or income stream that is denominated in money is potentially vulnerable to inflationary risk, because it will lose value in direct proportion to the decline in the purchasing power of money. Lending a fixed sum of money for later repayment as a fixed sum of money is the classic example of an asset that is subject to inflationary risk, because the money that is repaid may be worth significantly less than the money that was lent. Physical assets and equity are less sensitive to inflationary risk and may even benefit from unanticipated inflation.
For investors, bonds are an investment that is considered 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%, 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
The most fundamental way of protecting against inflationary risk is to build an inflation premium into the interest rate or required rate of return demanded for an investment. For example if a lender expects that the value of money will decline by 3% in the course of one year, they can add 3% to the rate of interest that they charge to compensate for the loss of value of money. Inflation premiums like this are implicitly built in to everyday market interest rates by lenders and borrowers. More serious inflationary risk occurs when the actual rate of inflation turns out differently from what is anticipated. Simply building an inflation premium into a require interest rate or rate of return when making an investment cannot adjust for unanticipated inflation.
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 based on the actual inflation rate.
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 a $1,000,000 bond investment with a 10% coupon. This might generate enough interest payments for a retiree to live on, but with an annual 3% 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.