The Effects of Inflation on the Bond Market

By Markets Fool.com

Bonds are fundamentally different from stocks, and investors count on the different ways that they react to changing conditions in the economic environment. The primary value of bonds is that they offer a predictable stream of future cash flow to investors, and the companies that issue bonds offer incentives in the form of interest payments in exchange for investors' commitment to lend them money. Yet the one thing that most bonds fail to take into consideration is how price changes can affect the purchasing power of the future cash flows that bondholders receive from the borrower. Below, we'll look more closely at how inflation affects the bond market.

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The direct impact: rising interest rates
The typical bond offers a fixed stream of payments, consisting of interest only during the lifetime of the loan and repayment of principal at maturity. The challenge in valuing a bond is that although you know what a dollar is worth currently, you don't know exactly how valuable it might be in the future.

The bond market builds expectations on inflation into their pricing models, and in general, bonds are priced to offer at least some real return on top of the projected inflation rate. Therefore, when inflation levels rise in a sustained manner, bond investors will demand a higher interest rate from the bonds they purchase in order to maintain a margin that will allow them to see their assets rise in purchasing power over time.

This has a couple of impacts. First, for existing bonds, higher prevailing interest rates in the bond market reduce the value of existing bonds that carry lower rates. Secondly, when issuers come to market to offer new bonds, they have to pay more in interest in order to find investors willing to lend to them. This combination is generally unattractive, and it explains why central banks are typically reluctant to let inflation send prices higher unchecked.

Second-order impacts
In addition to the immediate impact on interest rates, inflation also tends to lead to reduced bond issuance, restricting the amount of capital available to businesses and putting a drag on economic growth. For instance, in recent years, interest rates have been at rock-bottom levels, and hundreds of companies have taken advantage by locking in low financing costs through issuing longer-term bonds than they might otherwise have typically done. Conversely, higher interest rates from inflation make it more expensive for businesses to borrow.

Finally, high inflation levels spur interest in inflation-indexed bonds. These specialty bonds base their payments not on a fixed face value but rather on a maturity value that rises or falls depending on a particular inflation gauge. The size of the inflation-indexed bond market is tiny compared to that of traditional bonds, but when nominal rates are high, indexing bonds to inflation looks more attractive to borrowers.

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Bond investors typically don't like inflation, because the disruptions inflation causes are harmful to the value of the stream of payments that traditional bonds make. Nevertheless, inflation is a constant threat, so knowing how to handle it is crucial in order to be successful with your bond investing.

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