Inflation Will Eat Your Bond Returns If You’re Not Ready

Commentary

Bonds are typically considered a low-risk asset—although that perception shifted after the sharp increase in interest rates that began in 2022. People often refer to short-term U.S. Treasury bill yields as the risk-free rate. In reality, although bonds are less volatile than stocks, commodities, or cryptocurrencies, they are not without risk. Notably, the U.S. Treasury has never defaulted on its debt.

Still, bonds carry risks, and investors who don’t understand them may face unpleasant surprises. This was evident during the financial crisis of 2008, when AAA-rated structured note bonds defaulted, despite having been given the highest rating by credit agencies.

This article outlines the primary risks faced by fixed-income investors. These risks are not ranked in order of importance, as their severity and likelihood vary depending on economic conditions. For instance, after the COVID-19 lockdowns, bond prices declined, but investors were less concerned about default risk—especially with the Treasury ready to support the market regardless of how much money it had to create.

Credit Risk

The most commonly cited risk is credit risk—the possibility that the bond issuer may be unable or unwilling to pay interest and principal as promised. The greater this risk, the more interest the issuer must offer to attract investors. Credit rating agencies evaluate this risk and assign ratings. AAA is the highest rating. Ratings decline through AA(high) or AA+, eventually reaching BBB(low) for what is considered investment-grade debt. Many portfolio managers are restricted to holding investment-grade bonds. Bonds rated below that threshold—starting at BB(high)—are classified as high-yield, or “junk,” bonds.

High-yield bonds offer greater returns than investment-grade debt and have historically performed well. However, because they carry higher default risk, it is wise to invest in diversified high-yield bond exchange-traded funds (ETFs) rather than individual issues.

As of now, the average yield of the U.S. investment-grade corporate bond index is about 0.8 percent above comparable Treasury yields. The high-yield index yields nearly 3 percent more than similar government bonds. These “spreads” vary. When spreads narrow, corporate bond prices rise relative to Treasurys; when spreads widen, corporates underperform. This divergence was particularly notable during the 2008 crisis, when high-yield bond prices collapsed.

Liquidity Risk

Liquidity risk—the danger of not being able to sell bonds easily—becomes acute during periods of stress. In times of market uncertainty, corporate bonds—especially high-yield ones—can become difficult to trade, leading to steep price declines. Thus, liquidity risk and credit risk often go hand in hand.

For example, from May 2007 to November 2008, the ICE BofA Corporate Index spread versus U.S. Treasurys widened from 0.94 percent to 2.46 percent. On a 10-year bond, that increase could reduce the bond’s value by about 12 percent relative to Treasurys. For high-yield bonds, the spread soared from 2.46 percent to 19.88 percent in the same period. However, the 19.88 percent figure should be viewed with caution, as the high-yield market was largely frozen in November 2008.

Importantly, these market dislocations did not lead to widespread defaults. Spreads eventually narrowed, and investors who bought corporate bonds during the crisis earned significant returns.

Term Risk (Duration Risk)

A fundamental concept in bond investing is term risk—longer-term bonds fluctuate more in price than short-term ones when interest rates change. For example, a two-year bond might change by less than 0.2 percent for a 10-basis-point move in yield. A 30-year bond, on the other hand, might shift nearly 1.8 percent for the same rate change. This is why long-term bonds typically offer higher yields.

Reinvestment Risk

Reinvestment risk arises when future coupon payments are reinvested at lower interest rates. This risk can be more pronounced in longer-term bonds, as it’s harder to predict what returns will be decades from now.

Inflation Risk

Inflation is arguably the most insidious risk for bondholders. It often gets overlooked because of its slow and compounding effect. For example, a two-year bond at today’s inflation rate of about 3 to 4 percent will be worth about 4 to 6 percent less in purchasing power by maturity. Although the yield may partly offset this loss, the longer the investment horizon, the more uncertain future inflation becomes.

What truly matters is the long-term spread between bond yields and inflation. Consider this: A 30-year U.S. Treasury bond yields about 4.75 percent. If inflation averages 2 percent over that period, the investor achieves a positive real return. However, if inflation averages 7 percent—as it did in the 1970s—the real value of the investment plummets. After 30 years, a dollar would be worth $0.55 at 2 percent inflation, but only $0.13 if inflation averages 7 percent.

A Final Warning on Inflation and Debt

Inflation risk is particularly concerning for long-term investors. Governments around the world face mounting debt burdens. The U.S. federal debt-to-GDP ratio stands at approximately 125 percent. The sharp rise in interest rates in 2022 greatly increased the cost of servicing that debt.

Historically, governments have used inflation to reduce the real value of their debt, effectively repaying bondholders with devalued currency. This practice dates back centuries—and there is little reason to believe it won’t continue. Industrialized nations are unlikely to grow their way out of current debt levels. Ultimately, inflation may once again serve as the tool to “deflate” those obligations.

The views and opinions expressed are those of the authors. They are meant for general informational purposes only and should not be construed or interpreted as a recommendation or solicitation. The Epoch Times does not provide investment, tax, legal, financial planning, estate planning, or any other personal finance advice. The Epoch Times holds no liability for the accuracy or timeliness of the information provided.

Views expressed in this article are the opinions of the author and do not necessarily reflect the views of The Epoch Times.