You’ve heard of inflation, and you’ve heard of bonds. But how exactly are the two related? Well, when properly utilized, bonds can help you beat inflation and maintain the purchasing power of your money. They are a powerful addition to your investment portfolio – but you have to invest wisely.
What Is Inflation?
Inflation is the gradual increase in the price of goods and services in an economy, leading to a decrease in the purchasing power of money. As a monetary phenomenon, It also affects investments by eroding the real value of returns. Both the invested and uninvested have to fight inflation to maintain a consistent standard of living over time. As such, it is wise to consider inflation-beating strategies as part of your financial plan.
Some degree of inflation is considered advantageous for sustained economic growth, but it often doesn’t feel this way for consumers. Fortunately, you can protect yourself from the negative impact of inflation through strategic investments. This is where certain bonds could provide some symmetry to your portfolio of investments.
What Are Bonds?
A bond is a promissory note – or an IOU – issued by a government (municipal or sovereign bonds) or corporation (corporate bonds). Purchasing a bond means lending money to the issuer, who guarantees to repay the principal along with a specified interest amount in the future.
Bonds come in various types. In most cases, investors are locked into fixed rates of interest. This means that as inflation increases, the real value of those interest payments is decreasing. However, with certain types of US government bonds called TIPS, the principal value is indexed to inflation. This can help to protect the value of your money against devaluation caused by the increase of money in circulation.
How Inflation-Linked Bonds Help Beat Inflation
TIPS is short for “Treasury Inflation-Protected Securities”. Their principal value is adjusted with inflation, meaning it increases with rising inflation and decreases with deflation. Once the bonds mature, investors receive either the adjusted higher principal of their investment or the original principal value.
This sounds well and good, but the process can be misleading. TIPS offer long-term protection against inflation However, price fluctuations may outpace the principal adjustments during brief timeframes. It takes time for investors to receive the benefit.
The best way to make sure you’re choosing the right bonds is to get advice from an experienced financial adviser. Financial advisers are familiar with structuring inflation protection portfolios. They can assist individuals in selecting appropriate bond investments to safeguard against inflation.
Should Everybody Invest in Bonds?
Bonds are an ideal investment option for conservative investors seeking stable income and low risk. If you have sizable savings and a low tolerance for risk, bonds provide a more predictable return compared to volatile assets like stocks.
Investors looking to diversify their portfolios should consider bonds as a means of achieving a balanced asset allocation. Bonds can help mitigate overall investment risk by offering a counterbalance to the inherent volatility in equity investments. This leads to a more resilient financial strategy.
Choosing and Managing Your Bond Investments
Choosing and managing bond investments can be a complex process, requiring investors to understand different types of bonds and bond maturities. Of course, not everyone has time to do the kind of research necessary to make the best fixed-interest investment decisions. However, that doesn’t mean you can skip this step to establishing a robust investment portfolio.
Some people opt for buying the bonds with the highest coupons (the quoted interest percentage payable each year). Although this may seem like a logical choice, it will potentially introduce other forms of risk to your portfolio. One of these is “duration risk” which is an indication of sensitivity to changes in interest rates.
Financial advisers can help you navigate these complexities. An experienced financial adviser will be well-versed in matching bonds and investments to your individual risk tolerance and investment goals. They can also assist with ongoing fixed-income portfolio management, monitoring market conditions, and making timely adjustments to ensure the investments remain aligned with your financial planning objectives.