The Inflation Risk in Bond Investing - dummies

The Inflation Risk in Bond Investing

By Russell Wild

Although bonds are known for being safe investments, there is risk inherent in every investment. Bondholders do have first dibs on the issuer’s money. A corporation is legally bound to pay you your interest before it doles out any dividends to people who own company stock.

If a company starts to go through hard times, any proceeds from the business or (in the case of an actual bankruptcy) from the sale of assets go to you before they go to shareholders.

However, bonds offer no ironclad guarantees. All investments carry some risk, such as inflation risk.

If you are holding a bond that is paying 4 percent, and the inflation rate is 4 percent, you aren’t making anything. You are treading water. And that’s only if your interest is coming to you tax-free. If your bond is paying 4 percent, and inflation moves up to 5 percent, you are losing money.

Inflation risk is perhaps the most insidious kind of bond risk because you can’t really see it. The coupon payments are coming in. Your principal is seemingly intact. And yet, when all is said and done, it really isn’t intact. You are slowly bleeding purchasing power.

Although inflation rarely hits you as fast and hard as rapidly rising interest rates, it’s the fixed-income investor’s greatest enemy over the long run. Interest rates, after all, go up and down, up and down. But inflation moves in only one direction. (Well, we could have deflation, where prices fall, but that hasn’t happened since the Great Depression — except for a month or two here and there.)

Inflation takes its toll slowly and steadily, and many bondholders don’t even realize that they are losing ground.

Some bonds — Treasury Inflation-Protected Securities — are shielded, at least theoretically, from the risk of inflation. Most bonds (and bondholders), however, suffer when inflation surges.