Fixed Income Investing and Inflation

We often think of returns as being nominal, for instance imagining we get a 2% return or a 3% return from a fixed income investment. In reality though, returns are dynamic, and completely so. It’s not even that after inflation calculations of return are a different way to look at it, they are the only real way to do so.

It’s not that nominal rates of return, our 2% or 3% in this example, are meaningless, but they are only useful in comparing the rates of return between investments. 3% is 50% better than 2% of course, although we do need to account for other factors such as risk in deciding between these rates of return, but at least we have a way to compare the upside of investments.

One of the benefits of comparing fixed income investments versus comparing returns that are not fixed, such as stocks, is that we do not need to speculate on what return we will get, at least in most cases. As long as the interest rate or coupon rate is specified, we know what we will get back, and we could even say that instruments that do not specify return rates, such as zero coupon bonds, aren’t fixed income investments anyway, since the income is variable and not fixed.

These investments are still subject to speculation though, and aside from the risk of default, we also need to project or at least have an idea of what inflation rates may go to during the life of our fixed income investments, to even know how much we will get in real terms.

This is particularly important since many fixed income investors actually seek to derive their income from the investments, and therefore will want to make sure that the income earned will be, at a minimum, sufficient for their purposes.

If not, they may be well advised to consider mixing in other types of investments as appropriate, as for instance if going all in with fixed income will likely result in one’s needs not being met, this in a sense will guarantee failure to some degree, and striving for better may end up being wiser.

Net Yields From a Borrowing Perspective

When a borrower, a government or a company, borrows money from the public, inflation affects the net rate that they pay to borrow this money. The net rate that they pay matters to them as well, and it may end up that they may only pay a rate that is no higher than the inflation rate, meaning that they are essentially borrowing money at zero interest.

With U.S. 30 year treasuries for instance, the rates that these instruments pay and the inflation rate do tend to be very similar. Presuming that their rate of income keeps up with inflation, money raised through taxes in this case, they are essentially borrowing money for nothing.

This is the case with corporate debt instruments as well, although in this case, due to the higher risk, there will be a premium paid over the inflation rate, but this tends to be quite small with companies that are solid and don’t present much of a default risk.

We could even say that the rate that borrowers need to pay for borrowing through fixed income securities is the inflation rate plus the risk, and while these rates are fixed by the market, what kind of return people demand to lend this money, this does all work out to be very close.

This also works out this way for individual borrowers as well, where the rates we pay when we borrow are similar to the inflation rate plus the risk, and this is why the least risky borrowing, loans that are secured by prime real estate where borrowers have good income and a good credit history can end up with rates quite similar to the inflation rate, with higher risk lending requiring various risk premiums.

When we borrow this way, we may see our income rise with inflation and if it’s around what the cost of borrowing is, then we end paying little or nothing to borrow. The same principle applies to those who borrow through fixed income securities.

Why this is all important to realize is that all lending is based upon the inflation rate plus risk, and therefore this all ends up being pretty neutral, where if you get a higher nominal return you haven’t really benefited from the risk premium because you have to bear the amount of risk that is priced in.

This ends up being a great deal for borrowers though, where they can often borrow at what are essentially interest free loans, and those who are lending, the fixed income investors in this case, are just looking to break even on the deal and recoup what would otherwise be lost to inflation.

Keeping Up With Inflation

Doing absolutely nothing though, putting your money in a box for instance, will incur losses over time on their money, equal to the rate of inflation, so looking to prevent these losses is indeed important.

In order to get the truest sense of what we are doing with fixed income investments versus other approaches to investing, we do need to realize that fixed income returns are actually quite small, from nothing to a very small net rate of return, at least with fixed income investments that are low risk.

When we take on more risk, for instance buying risky bonds, or investing in stocks and looking for capital accumulation, there is of course the risk that this will not end well for us, losing money on the bonds or seeing stock prices decline during our investment horizon.

When we introduce risk to investments, this brings in the element of skill, for instance with the increased returns one may achieve by picking the right stocks or timing the holding of them beneficially.

There is no skill involved in fixed income investments though, at least if they are held in order to earn income and not traded, and we are therefore relegated to just breaking even or coming very close to that over time.

Many investors do not have the skills to seek to manage these risks and their investments though, nor do they have the disposition or courage to acquire these skills, and many turn to just looking to basically keep up with inflation and take the defensive posture of not losing with their investments rather than looking to actually grow them.

If one is seeking to grow their portfolios at a rate higher than inflation in fact, investment advisors will advise that one take on more risk than this, because the risk free return is the rate of inflation essentially. This will take us out of the realm of fixed income and into more risky investments, where we then need to look to manage these risks well enough to gain an advantage and actually achieve returns that are higher than inflation from a probabilistic perspective.

Losing to Inflation with Fixed Income Investments

Aside from the risk of a fixed income investment defaulting, where we may lose principal, there is also the risk present with losing money to inflation, and this risk can be significant.

When we purchase a fixed income investment, the rate of return is set by the market and economic conditions of the day, where for instance we’re collecting what the rate of inflation is at the time or close to it.

Inflation rates change though, and when they do, this will impact the net return of these investments. This is particularly impactful given the longer terms that fixed income investments are held, often for many years.

When interest rates go down, the value of our income stream goes up. For instance, if we are receiving 4% on an investment and the interest rate at the current time is 3%, we are earning a 1% premium over it, as well as a 1% net return.

It is this 1% that matters, even though it may seem that we are earning 4%, we are, but we’re also losing 3%, so we’re ahead by this 1% in this case.

This can and often does go the other way though, where inflation goes up and this can end up seeing us experience negative returns, where for instance our rate of return may be 3% and inflation may be 4%, for a net return of -1%.

This particular example may not be that significant, but inflation can rise a lot more than this, although in recent times inflation has been kept well in check. Even though nominal rates of return do rise during inflationary periods, if you’ve locked in a lower rate previously, you are subject to the risk of this income stream being significantly devalued over time if interest rates rise enough over the life of the investment.

Comparing Inflation Risk with Investment Risk

What makes this such a big deal with fixed income investments is that if we are counting on this income to manage our day to day affairs, losing quite a bit of buying power to inflation can indeed be troublesome, and this risk is the main one by far with fixed income investments.

When people contemplate investment strategies, this inflation risk can be under accounted for or even ignored, which ends up seeing us focus too much on investment risk and may end up having us seeking out investments with little or no investment risk but significant inflation risk.

This can be a particular problem during periods of rising inflation, and while stock markets don’t like inflation, bond markets hate it much more, and the price of bonds can decline significantly during periods of rising inflation.

This can have the fixed income investor in a spot, where we are getting less for our money and if we look to sell the investments we’re also going to get less, often times experiencing a significant capital loss.

The rates that fixed income investments simply do not provide the returns to really make up for larger capital losses, so it’s not like we bought a stock pretty cheaply, it’s going down now but we’ve made quite a bit of money riding it up.

With fixed income investments, it’s more like we’ve made nothing essentially on them and now we have to lose part of our principal.

It’s not that fixed income investments are a poor choice, and they can be a good choice in fact under the right circumstances, for those investors who want or need a steady stream of income with a minimal amount of investment risk, but we also need to well heed whatever interest rate risk may be present in order to really make an informed decision.