The Fixed Income Trap U.S. Inflation Creates
Economists measure this using a tool call “net present value”. NPV is an attempt to level-set future cash flows by taking into account inflation or the time value of money.
In this last example, we will compare two scenarios. Scenario 1 is the cash flow of a $1,000 bond with a 5% yield in a 2% inflationary environment. This would equate to a coupon payment to the bond holder of $50 per year. The net present value of that $50 slowly deteriorates each year due to the inflation rate of 2%. That final, 10th year payment has a NPV of just over $41.
Scenario 2 is a situation where the bond yields 2% but inflation is at 5%. This means the bond pays a coupon of $20 annually, but that $20 loses value more quickly since inflation is 5%. Unfortunately, the final coupon payment is only worth $12.28 in NPV terms.
The graph below shows the net present value of the cash flows over ten years.
Scenario 1 is an acceptable situation, but Scenario 2 is doubly cursed. The yield from the bonds is starting at a low base. Making matters worse, the value of those paltry payments diminishes with the higher inflation rate. Finally, if we tally up the NPV of the income payments and principal values of both scenarios, we get the following:
The math is simple. In the low-yield, high-inflation scenario, the bond holder loses. Unfortunately, Scenario 2 is much closer to today’s reality. Because of this tricky scenario, investors may want to consider bond alternatives.