The potential negative consequences of inflation are far too numerous to discuss within this short post. We will instead focus on inflation’s impact on portfolio construction, particularly upon the bond or fixed income allocation. For decades bonds have served a significant dual role in portfolio construction, providing investors with a decent level of income as well as capital preservation.
Rising inflation undermines both of those key roles. Most bonds literally provide a fixed amount of income; few bond yields adjust for rising interest rates. In absolute terms, the income received from bonds has been quite low ever since the Global Financial Crisis of 2007-09. However, the value of that meager income is further undermined by rising inflation.
For example, a $1,000 investment in a 30-year Treasury bond with a 2% coupon will pay you $20 a year. That’s not a lot to get excited about. But if prices are rising 3%, 5%, or more every year, that fixed $20 payment will look less and less attractive every year.
Moreover, the monetary policy tool used to halt inflation is to “cool down” the economy by raising interest rates.
If the “cure” for inflation is to raise rates to 4%, 6%, or whatever the appropriate level might be, how valuable is a bond that is locked in to a 2% payment every year?
Not very valuable, unfortunately. The price of a 2%-yielding bond will fall, and significant capital losses are certainly possible for what many people consider to be a “safe” investment.
We have seen this phenomena of rising interest rates/falling bond prices play out on a short-term, cyclical basis before, as the charts below illustrate. However, it has been a long time since we’ve entered a secular period of high inflation, rising interest rates, and true, prolonged pain in the bond market.