There are many different categories
of fixed income investments and the impact will vary somewhat depending on
type, credit quality, and when the investment matures. But generally, inflation
affects them all in a couple of ways:
If you own a bond or bond fund that’s
yielding 3.0% and the cost-of-living rises to an annualized 4.0%, then your
purchasing power is going backwards by 1.0% (annualized) during the period in
Decline in Principal
If inflation rears its head and
central banks raise interest rates to combat it (or the bond market
collectively pushes rates up), then the principal value of your bonds (or bond
funds) will decline during that time. Why? Because nobody will pay the same
amount for an older bond with a lower interest payout vs. a newly-issued bond
with a higher payout. Think of it like a teeter-totter: when the interest rate side goes up, the
principal value side goes down, and vice-versa.
An oversimplified example: Say that interest rates rise and anyone can
buy a new $10,000 bond paying 4.0% ($400 annually). You already have a similar
bond paying 3.0% ($300 annually). If you need the money and have to sell your
bond now, you’d probably have to unload it at a steep discount for around
$7,500. $300 interest divided by $7,500 = 4.0%, just like $400 interest divided
by $10,000 = 4.0%.
On the other hand, if you don’t
have to sell now and the issuer of your bond is stable, you could hold it to
maturity and get back all your principal value. That’s the case for an
individual bond. But bond funds are impacted differently because they hold a
revolving supply of bonds with different maturities.
Hope that helps.
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