How Does Inflation Affect Fixed Income Investments? (2024)

Fixed income investment is a category of investment focused on preservation of income and capital, and entails consistent and regular returns for investors. By investing in fixed-income investments, investors are entitled to a series of interest payments that are considered as fixed income.

Fixed income investments include interest paying instruments such as treasury bonds, corporate bonds, commercial paper (CPs), corporate FDs, and certificates of deposit (CDs). These investments are less volatile than the stock market and can balance out the risk in the portfolio to offset volatility during a stock market downtown.

A well-diversified portfolio typically includes fixed-income investments. These investments are generally low-risk and are often used to diversify portfolio and to preserve wealth and generate a steady source of income.

What is Inflation?

Inflation is a measure of the rate at which the general level of prices for goods and services rises resulting in a decline in purchasing power. Inflation is a complex economic phenomenon that can arise from a number of factors including increased demand to changes in the supply of goods and services, decrease in the supply of money and credit, rising labor costs, raw material costs, reducing expenditure, and taxes.

Inflation is a key macroeconomic indicator that influences the activities in an economy. It can have a significant impact on the entire economic ecosystem including banks, policymakers, and investment avenues and can hamper individual investments. Capital markets tend to see a downtrend during inflationary times. Inflation impacts the returns yielded from investments. Even though fixed income instruments are stable in most cases, they are not immune to inflation.

Impact of Inflation on Fixed Income Investments

Fixed income investments are impacted significantly due to inflation. As inflation rises, the interest rates for fixed income instruments remain the same, triggering investors to explore or invest in alternative investments in order to get returns higher than inflation rate (in order to beat inflation). The interest rates generated through fixed-income investments are generally lower as compared to the higher rate of inflation.

• Bond prices are inversely rated to interest rates. Inflation causes interest rates to rise, leading to a decrease in value of existing bonds. During times of high inflation, bonds yielding fixed interest rates tend to be less attractive.
• Not all bonds are affected by interest rates in the same way. Bonds with a longer maturity are more sensitive to changes in interest rates, and therefore, more affected by inflation. Inflation impacts the real rate of return of fixed-income investments. This decrease in real return makes the bond less attractive to investors, leading to a decrease in bond prices.

Inflation reduces the purchasing power of income generated from a fixed-income investment. Investors tend to reinvest their income in order to maintain their purchasing power.

To control inflation, the central bank or regulatory body can intervene and announce measures to adjust credit policy, introduce additional liquidity into the economy and manage yields on debt products. These actions are typically taken when the inflation rate rises to unsustainable levels.

By managing money supply and introducing additional liquidity into the system, central banks can help prevent excessive inflation and provide a buffer against economic downturns. Furthermore, by controlling the yields on debt products, central banks can affect the incentives of borrowers and lenders and which can have an impact on the overall inflation rate.

How To Mitigate Fixed Income Investments Risks Arising From Inflation

While fixed-income investments are subject to inflation risks, there are several strategies that investors can use to mitigate risks.

• Investing in inflation-indexed bonds: Inflation-indexed bonds provide investors a fixed rate of return that is linked to the prevailing rate of inflation. This means that the investors would be able to maintain their purchasing power by investing in these bonds. Additionally, investors can also consider investing in mutual funds and exchange-traded funds (ETFs) that invest in inflation-indexed bonds, thereby hedging against losses due to inflation.

  Similarly, investors can consider putting their money in inflation-protected bonds such as treasury inflation protected securities (TIPS).

  See Also

  Inflation brings benefits to which one of the following?

• Diversifying the portfolio: Diversification of portfolio is one of the most effective strategies to mitigate risks during market volatility. Investors should consider investing across different asset classes such as stocks, bonds, and cash. This allows investors to benefit from the upside potential of equities while also protecting against downside risks with bonds and cash.

• Bond ladder as an investment strategy: A bond ladder is essentially a vast portfolio of different bonds that mature at different dates. Investors can consider buying bonds with different maturities, so that when one matures, the proceeds are reinvested in a new bond and investors continue to receive interest income from multiple bonds.

• Floating rate funds: Floating rate funds are another example of debt instruments that work in the favor of investors during inflation. Floating rate funds does not have a fixed interest rate; instead, they are revised in accordance to fluctuating interest rates as per prevailing market conditions

Bottom Line

As an investor, it is important to diversify the portfolio in order to prevent oneself from adverse effects of market volatility.

Investing in a mix of fixed income assets such as treasury bills, corporate bonds, and debt mutual funds can help hedge against the risk of inflation and provide investors with a steady stream of income. Additionally, investing in assets with long-term maturities such as long-term bonds can help protect against inflationary pressures as they are less likely to be affected by short-term market volatility. Investors can also take exposure to assets like equity which tend to beat inflation over the long term. .

In every evolving economy, inflation is an inevitable phenomenon, which affects long term yields. It has the potential to erode the value of fixed-income investments over time, so it is essential for investors to carefully consider the long-term goals, financial liabilities and risk appetite before taking investment decisions.