How does Inflation affect bonds?

5 min read 17 Aug 23

Inflation has been stealing the headlines for a while now. It’s likely we’ve all felt the impact to some degree. Given the high interest rates we’re experiencing these days, it might feel like saving is the best thing to do. High inflation can cause people to worry about their investments. However, holding cash in a high-inflation economy could shrink your overall wealth and spending power over the long term. So what other options do we have?

Investing is generally considered a practical way to get your money working harder so it can keep up with inflation. There are a number of ways to invest and a range of assets to choose from. In this article, we’ll explore the world of bonds – a common way to invest and generally considered lower risk than buying company shares. We’ll explain what they are, how they work and the impact inflation can have if you decide to invest in bonds either directly (by investing yourself) or with an investment fund that’s looked after by a professional fund manager on your behalf.

Please remember, that the value of your investment can go down as well as up so you might not get back the amount you put in.

What are bonds?

  • A bond is really just a loan
  • When you buy a bond, you’re lending money to the government or company that issued it
  • Most should give you regular interest payments in return for the loan, plus the original amount back at the end of the loan term (the maturity date)

Bonds can help to reduce risk

Bonds are generally considered a lower-risk way to invest compared to other asset types such as stocks and shares (also known as equities, or shares of ownership in a company), therefore, they can play a key role in a diversified investment portfolio. So having them in your portfolio during a time of financial uncertainty, or if you’re approaching retirement and looking for a more cautious approach to investing, may prove to be valuable.

The main way bonds work is that you could receive a steady income as well as your original investment back at the end of the loan period. As the interest is fixed when you buy a bond, you’ll generally know how much you’ll receive, and when it will be paid to you. And if you’re relying on your investment for income, receiving the regular interest payments from bonds can make it easier for you to plan ahead.

A number of factors might cause bond prices to rise or fall

You pay a fixed price when you buy a bond when it’s issued. However, you can trade the bond with other investors, a bit like how you can with shares. So, when you buy or sell a bond in this way, its ‘market’ price will be affected by a number of factors, one of which is inflation. 

How does inflation affect bonds?

While bonds are commonly used to manage risk in portfolios, high inflation can affect their performance. This is because the income they pay will normally be fixed at the time it’s issued. For example, if a bond is offering an interest rate of 5%, and inflation is running at 4.5%, in reality, you only really get a 0.5% return. This means that bonds tend to become less attractive (and therefore, their prices fall) when inflation is rising. Alternatively, if inflation is falling, a fixed interest of 5% becomes a lot more appealing in theory.

Don’t go it alone

Investing in bonds may not be the easiest thing to do. It can also be challenging trying to maintain a diversified portfolio at the same time as managing your risk. So rather than going it alone, why not speak to a financial adviser to see what options are best for you. If you haven’t already got a financial adviser and would like to speak to someone, you can find a financial adviser here.

The decisions fund managers make can tell you a great deal about their expectations for markets, trends, interest rates and of course, inflation in the future too. For example, if they’ve recently added more bonds to your fund, it could mean they expect to see inflation slow in the short term, in specific regions. And the opposite might apply when they reduce the amount of bonds they hold.

But of course, different types of bonds, like high-yield corporate bonds, and those from different countries around the world, can all act differently because of their own ‘local’ conditions. This is even more reason to invest with experts on your side. They actively position funds according to the in-depth market analysis, research and insight at their fingertips, to help their investors achieve their long-term goals. 

The views expressed here should not be taken as recommendation, advice or forecast. We are unable to give financial advice. If you are unsure about the suitability of your investment, speak to your financial adviser.

By M&G Investments

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