Bonds can provide a head start in an investor’s race against inflation…

Bonds are called “fixed income” because (99+% of the time) the amount and the timing of the interest payments and principal repayment are predetermined. This means investors know exactly what their annual return will be – assuming they hold the bond from issuance to payoff.

The market – shorthand for all investors – allocates capital. Bond buyers are willing to lend on terms that they expect will generate a “real” return that exceeds the inflation rate. When a bond is issued, its pricing embeds the lenders’ consensus about many factors, most notably how much the cost of living is projected to rise.

In practice, this consensus changes continuously. If inflationary expectations rise, new lenders will require a higher rate of return – and a lower one if the outlook for the general price level gets rosier.

For example, assume the U.S. Treasury issues a 10-year bond that pays 5% annually. If inflation at the time is expected to be about 3% annually, the real return would be 2% per year. For each $1,000 face value, the buyer would receive $25 every six months, and $1,000 back at maturity.

Now assume the market becomes more concerned about inflation and the market interest rate for a new 10-year Treasury bond rises from 5% to 6%. To sell the 5% bond at the market-clearing 6% yield, its price needs to fall by $70 per $1,000. The buyer paying $930 and receiving the same $50 a year is now earning 6% yield. By the same logic, if the market interest rate on the new 10-year Treasury bond were 4% instead, the price of the 5% bond would rise by roughly $80. At $1,080 its yield to maturity for a new buyer would be 4%.

Bond prices swing when market-driven interest rates change, and the longer the bond maturity, the sharper the price movement. If we were to repeat the last exercise using a recently issued 30-year bond with a 5% coupon, the price would fall to roughly $860 to yield 6% annually or rise to $1,170 to return 4% per year.

In other words, rising interest rates are bond predators. Much (but not all) of the time, interest rates rise when concerns about inflation pick up and fall when those concerns subside.

In 1997 the U.S. government took steps to reduce bond volatility by introducing Treasury Inflation-Protected Securities (“TIPS”). These securities offer protection from inflation by indexing the $1,000 face value to the level of the consumer price index (“CPI”). Every six months from the date of issuance through its maturity date, the bond’s principal amount changes to reflect movements in the CPI during the period.

Though the interest rate on TIPS is fixed, the semi-annual interest payments go up in proportion to the bond’s increasing principal value. In this example, we assume a 10-year inflation-protected treasury bond, a 2% coupon, and annual CPI increases of 3%.

The interest rate on inflation-protected bonds is lower than on standard Treasury bonds. In this case, the low coupon and modest inflation rate lead to an annual return of roughly 5%.