How Does Inflation Affect Fixed Income Investments? (2024)

What are Fixed Income Investments?

Fixed income is a category of investments focused on preserving income and capital that provides consistent and regular returns for investors from a series of interest-paying funds.

Interest-paying investments include 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 the portfolio’s risk to offset volatility during a stock market downturn.

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

What is Inflation?

The inflation rate measures the fall in prices of goods and services resulting from the decline in purchasing power. Inflation is a complex economic phenomenon that can arise from a number of factors, including increased demand for the supply of goods and services, decrease in the supply of money and credit, rise in labor and raw material costs, reduction in expenditure, taxes, etc.

Inflation is a key macroeconomic indicator that influences an economy’s activities. It can significantly impact the entire economic ecosystem, including banks, policymakers, and investment avenues, and 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 usually stable, they are not immune to inflation.

Impact of Inflation on Fixed Income Investments

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

• Bond prices are inversely rated to interest rates. Inflation causes interest rates to rise, decreasing the value of existing bonds. During 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 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 the 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, which can impact the overall inflation rate.

How to mitigate fixed income investment risks arising from inflation?

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

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

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

• Diversifying the portfolio: Portfolio diversification is one of the most effective strategies for mitigating 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 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. They do not have a fixed interest rate; instead, they are revised in accordance with fluctuating interest rates as per prevailing market conditions.

Bottom Line

As an investor, it is important to diversify the portfolio 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 inflation risk and provide investors with a steady income stream. 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 inevitable and 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 making investment decisions.