Bond prices are linked to interest rates and rising inflation makes interest rates go up. So let's start by understanding what exactly inflation is and its characteristics.
What is Inflation?
Simply put, rising level of prices for goods and services is known as inflation. Inflation decreases the value of money. When inflation rises, one is able to buy lesser with similar amount of money.
Inflation levels are measured by Consumer Price Index (CPI). CPI is a weighted average of prices of a basket of goods and services. To calculate CPI, the prices of each of the items in the basket is calculated at different times and the weighted average is determined. Changes in the CPI help in determining the levels of cost of living. The CPI is calculated every month.
For e.g. let's assume that the basket for CPI calculation consists of the following items in base year, Year-0
Item | Quantity | Rate | Cost |
Wheat | 5 kg | Rs. 18/ Kg | Rs. 90 |
Rice | 3 kg | Rs. 35/kg | Rs. 105 |
Dal | 2 kg | Rs. 130/kg | Rs. 260 |
Bread | 20 pieces | Rs. 5/piece | Rs. 100 |
Apple | 500 gm | Rs. 200/kg | Rs. 100 |
CPI in base year | Rs. 655 |
The same basket may have different values at a different time 'Year-T' according to the following table:
Item | Quantity | Rate | Cost |
Wheat | 5 kg | Rs. 20/kg | Rs. 100 |
Rice | 3 kg | Rs. 40/kg | Rs. 120 |
Dal | 2 kg | Rs. 125/kg | Rs. 250 |
Bread | 20 pieces | Rs. 6/piece | Rs. 120 |
Apple | 500 g | Rs. 180/kg | Rs. 90 |
CPI at time T | Rs. 680 |
Inflation isn't necessarily bad, per se. Some level of inflation is needed for the producers (e.g. manufacturers, service providers, etc.) in the economy to have an incentive to make progress in their economic activities. However, like many things in life, anything in excess or severe shortage is bad.
How does it impact bond performance?
When inflation is up, the RBI may want to reduce the money supply within the economy. One way RBI does this is by increasing the short term interest rates so that from RBI to banks to retail consumers, everyone borrows less money and decreases spending. This is also termed as contractionary monetary policy. Since Bond prices and interest rates have an inverse relationship, this implies lower value for bonds.
Nominal Return vs Real return
There is another risk which bonds face due to rise in inflation. That risk is the difference between the nominal return and the real return. The nominal return is what a bond or bond fund provides on paper. The real return is adjusted for inflation.
Nominal Return - Inflation = Real Return
Eg: If a particular set of items cost Rs. 100 this year, with an inflation of 3% it would mean the same set of items would cost me Rs. 103 a year later. Taking this scenario into account, if you hold a bond with a yield of 1% at a time when inflation is 3%, over the year the value of Rs. 100 investment would be 101 rupees before taxes. But in real terms, inflation would have eroded your purchasing power by 2 rupees. The real return was -2%.
In such a situation investors need to keep in mind the present inflation rate before investing in bonds. It is also vital to remember inflation compounds each year, just like investment returns.
If your goal is to build a substantial amount for the future, a bond or bond fund that pays above the inflation rate should be the one to invest in. For safety one could consider a more diversified approach, by adding medium-to high- risk investments such as high-yield bonds, investment-grade bonds and equities.
Bond portfolio diversification could be a complex topic. Investors are advised to consult their advisors to understand the impact of any investment decision on their wealth. Bondskart also has a team of advisors who investors could consult before making their investment in bonds. Please contact us to know more!