The Significance Of Inflation On Bonds
The significance of inflation on bonds is a result of how inflation influences the 'real' yield of a bond.
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We just have a quick question here from Rolando asking about bonds and how inflation affects bond prices. Now in our daily risk and outrigger report for today, we spoke about the UACPI being coming up, and how a higher than expected CPI print can actually effect the bond market and how it can affect things like TIPS and gold and Rolando just wants some more information and clarity on this.
So one of the key correlations to bonds and bond yields are real interest rates.
Now real interest rates are simply just inflation adjusted interest rates. So let's say your yield on a 10-year US government bond is 1% but inflation is currently tracking at 1% as well. And then you essentially have a real interest rate of 0% on that bond. And why that matters for bonds, specifically comes back to the future value of money.
So remember when you buy a 10-year government bond for let's say a 1000 bucks and you buy it at a coupon rate of 2%. You will essentially get paid 2% of a $1000, which is $20 every single year in interest for lending the government that money and then you will, of course, get your money back after the 10 years.
Now since your interest payment or your coupon payment is fixed for the entire 10 years of the bond's lifetime, the value of that coupon payment in real money terms will get less and less each year as inflation rises.
So if you bought it with a coupon rate of 2%, but inflation shoots up to 3%, then you are essentially losing 1% in real money or future value of your money as long as real interest rates are negative. So if you bought a bond let's say at 2% yield, but inflation is expected to rise to let's say 3% in the next few years, that makes your bond less attractive, because if inflation reaches let's say just 2% and you bought it at 2% in the next few years, your yield will drastically diminish as you will get back the price that you paid for the bond but inflation means that the actual future value of that money goes down a lot.
So what usually happens to the bond market with inflation data and inflation expectations are bond prices usually go down when real interest rates decrease basically when inflation moves up and vice versa, they go, bond prices basically go up and your yield will go down when you have real interest rates increasing with inflation going down.
Now when you are in an economic climate like we are now post COVID, investors still want to hold on to bonds right? So bonds are still considered as a goto asset right now, as a goto asset class from a safe haven perspective.
So what do investors do? They still want to basically keep their cash safe in safe havens, but they don't wanna you know put their money necessarily into equities, because it might be too risky. If there is recession, they still want to keep bonds but they don't want to just hold their money in bonds and cash if inflation is going to just eat away at the value.
So what they can then opt to do is they can rotate their bonds, they can basically sell their bonds and rotate into things like gold. Or they can still buy bonds, but they can buy treasury inflation protected securities, which is basically it's known as TIPS, which is basically just inflation-protected bonds that you buy, so even if you buy it, you know you will be protected by the drastic increases in inflation if it should shoot up. So those two namely gold and TIPS are usually classic hedge against inflation so that you know you're still holding your cash in bonds...
You're still holding your cash in bonds. You are still invested in safe havens, but they're just now inflation protected or you can just you know opt for buying something like gold. And for that reason you can only see a very close correlation between something like TIPS and gold as well.
So I hope that this clarifies the relationship between bonds and inflation there Rolando, but of course any other questions, please don't hesitate to let us know.
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