The Effects of Inflation on Bonds

The least risky bonds will offer inflation protection. This is a way of assuring the value of a dollar does not depreciate to a level that makes the ultimate repayment of a bond much less than the initial expected repayment. Few bonds offer protection from inflation explicitly, but they all should attempt to hedge against this possibility through their pricing and yield structures. Some bonds do have explicit protection.

Inflation and Short-Term Bonds

Short-term bonds have a lower risk of being significantly affected by inflation. Over a short period of time, even if inflation is high, the value of a dollar should not change drastically. For example, pricing indexes during the course of a year show much less change than pricing indexes over five years or 10 years. Short-term bonds tend to have lower interest rates because they do not have to compensate for the risk of inflation to a great degree.

Inflation and Long-Term Bonds

Long-term bonds carry a much greater risk of losing their value due to inflation. If you hold a bond for 10 or 25 years, you can expect the price index to change drastically. Simply receiving your principal in return would represent a loss. If the interest rate on the bond is too low, you would have been better off placing the money in a conservative savings account rather than purchasing a bond in this situation. This is a risk with low-yield, long-term bonds. To compensate for this risk, most long-term bonds are offered in higher yield options.

Bond Yield and Inflation

Both corporations and municipalities consider the impact of the risk of inflation when they set yields. As a result, short-term bonds will ultimately have lower yields than long-term bonds. You will have to weigh the risk versus reward of a long-term purchase. In addition to the risk of inflation, corporate bonds carry a greater risk of default if they are issued in a long-term format. Treasury bonds or local municipality bonds have a lower risk of default. Therefore, long-term corporate bonds often have the highest potential for earnings since they are considered the riskiest options. When you elect a long-term corporate bond, consider its potential payout when compared to both safer bond options and corporate stock options.

Inflation-Protected Bonds

A few unique bonds do protect against inflation. The Treasury issues I Bonds or TIPS bonds that have two separate interest rates. The first interest rate is the promised payment due to yield for your investment. The second interest rate solely compensates for inflation. If inflation is high, the second interest rate is added to the first to assure you get your money's worth on the investment. If deflation occurs, the second interest rate may actually be subtracted from the first. However, you will never earn back less than you paid to purchase the bond in the first place. These options can be very attractive for college or retirement savings due to the added protection plus additional tax benefits.

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