The Effect of Inflation on Fixed-Income Investments
The Effect of Inflation on Fixed-Income Investments
Fixed-income investments, such as US Treasury bills and most bonds, generate income for their investors by paying out a set rate of interest.
Things To Know
- The real interest rate is the rate of return adjusted for inflation.
- You will need to exceed inflation if you want to maintain your purchasing power.
What those numbers mean
Generally, when you think about interest rates, the nominal interest rate is what you are thinking about. The 6 percent interest rate on a mortgage, the 3 percent rate on a Treasury bill, or the 5 percent rate on a corporate bond are all examples of nominal interest rates.
A real interest rate, by contrast, is the rate of return adjusted for inflation. It measures the rate of growth of your purchasing power.
An example
If you invest in a bond that pays out 6 percent annually, and inflation averages 6 percent over the course of your investment, your real return is 0 percent. In terms of purchasing power, you have gained nothing by investing your money in this bond. The good news is that you have not lost anything either. If you had invested in a bond that provided a 3 percent nominal rate of return, you would have lost 2.83 percent in terms of purchasing power.
How to figure it
Let’s look at the formula for calculating real interest rates:
Why even real interest rates are uncertain
The fact that future inflation rates are uncertain makes your future real interest rate returns uncertain as well. Even though an investment may guarantee you a certain nominal rate, there is no guarantee that you will achieve your desired real rate of return. The best that you can do is to attempt to predict future inflation rates or look at others’ expectations of future inflation and base your investment decisions accordingly.
How to stay ahead of inflation
If inflation is high, you will need a proportionately higher nominal rate of return to ensure that you receive your expected real rate of return on your fixed-income investments. For example, to get a real rate of return of 4 percent in a 3 percent inflationary environment, you would need a nominal rate of return of 7.12 percent.
As you can see, inflation lowers the real return on fixed-income securities.
