Taylor Says

by Taylor Kovar

How does inflation affect bonds?

Hi Taylor: 

Inflation is having a pretty obvious effect on pricing, but I’m wondering what it means for investments? Do I need to buy bonds, sell bonds, ignore bonds? What’s the connection there? - Tim

Hey Tim: 

Great question. People talk about interest rates and inflation as they relate to stocks and bonds, but the conversation usually stops short of explaining the actual economics of it. With bonds in particular, you really need to know how this stuff works. So here we go, Inflation, Interest & Bonds 101 with Taylor Kovar!

  1. Increasing interest rates are a bond’s worst enemy. Your bond’s coupon rate, or the annual interest rate, is set at the time of purchase (usually, not always). If interest rates are about to go up, and that’s what we’re seeing right now, future bonds will have a better yield. That wouldn’t matter as much if a bond’s value was static, but that isn’t the case. When bonds with higher coupon rates become available, the older bonds lose value. This is especially true if you’re holding something that now has an interest rate below the current rate of inflation. While your investment won’t become totally worthless, it takes a hit in the short term and won’t deliver meaningful returns until rates go back down. 

  2. Inflation is the root of the problem. The interest rates that hurt your bond’s value rise in response to inflation. We’ve been dealing with an inflation spike for months now, but, as you said, that’s been most noticeable with the price of goods. As the markets respond to inflation and the central banks start hiking interest rates in order to curb it, that’s when investors consider dumping their bonds. A lot of people view bonds as long-term holdings, but when indicators of an interest hike are particularly strong, investors will sell bonds in advance and then buy again when they can get a better coupon rate. If you wait too long to sell, no one will want your old bond because it won’t keep up with the newer, higher-yield bonds. 

  3. Diversify. As always, the solution to this problem is to not put all of your investment capital into bonds. Personally, I think stocks may be a better alternative. While bonds are at the mercy of inflation and interest, individual stocks typically keep up with inflation. The “safety” you get from buying a bond comes at the expense of your earning power, and that’s playing out in real-time as inflation and interest rates disrupt the bond market. 

Prolonged inflation hurts everyone, so let’s hope things turn around before too long. Expect interest rates to rise while we wait for inflation to retreat, and act accordingly with your investing—bonds or otherwise. Thanks for the question!

Taylor J Kovar
CEO | Kovar Wealth Management
Phone: (936) 899-5629
Firm: KovarWealth.com
Blog: GoFarWithKovar.com