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Bonds & inflation: What you need to know

Even though bonds are traditionally considered relatively safe investments, bond investors still face several risks. For instance, bonds and inflation generally do not mix well, and the combination can potentially lead to losses. However, even amid rising prices, that doesn't necessarily mean you should eschew bonds as a part of your investment strategy.

Instead, it's crucial to understand how bonds work and manage risk in your long-term investments. If you're thinking about adding bonds to your portfolio in the hopes of providing for your family's future, here are some key details to know.

The basics of bonds

Bonds are debt instruments. Organizations issue bonds when they want to borrow money, and in turn, investors earn interest when they invest in bonds. That's an oversimplification, though—things can get more complicated.

Various types of organizations issue bonds. For instance, you might buy bonds from:

  • The U.S. government
  • State or municipal government bodies
  • Companies inside the U.S. and abroad
  • Foreign governments

When you buy a bond, the issuer typically pays interest and then returns your initial investment after a specific length of time. For example, you might pay $1,000 for a five-year bond that pays interest every six months. In that case, you'd get a series of interest payments for five years, and then you'd get your $1,000 back when the bond matures (assuming the issuer does not default).1

Some bonds, such as zero-coupon bonds, do not make periodic interest payments. Instead, you get your principal back at maturity—plus extra money that represents your earnings.

Bond yields

A yield is a way to measure the return on investment from a bond. For instance, say you buy a $1,000 bond that pays out $20 every six months. You stand to receive $40 of interest over the year, so the bond's yield at issue might be quoted as 4%.

To calculate the yield, divide the annual earnings into the purchase price. So, you'd divide $40 by $1,000 to arrive at 0.04, or 4%.

Bond prices can fluctuate in value, so a bond's yield might depend on when you purchase it. For instance, if the bond above loses value and is worth only $800 when you buy it, your yield at purchase would be 5%. Again, you'll divide the income of $40 into the purchase price of $800 for a result of 0.05. The bond's interest payment (also known as the coupon) generally does not change due to market fluctuations.

Why might a bond's market value change? The bond can become more or less attractive to investors for various reasons, outlined below. As just one example, interest rates often rise in response to inflation. If that happens, issuers might offer new bonds that pay 5%. Similar bonds that pay 4% may decline in price because they are less attractive than 5% yielding bonds. Conversely, in periods of falling interest rates as inflation declines, bond prices have generally risen as existing bonds with higher yields become more attractive than newly issued bonds at lower yields.

How yield curves work

A yield curve is a visual tool for displaying the interest rates on various bonds. It can help you see what yields are available to choose from. For instance, shorter-term bonds tend to have lower interest rates compared with longer-term bonds, but that's not always the case. A short-term bond often involves less uncertainty, so the yield is typically lower. Meanwhile, longer-term bonds generally come with more uncertainty. Predicting the future is always impossible, but you can be more confident about conditions in the next three months than in the next 10 years.

To view the difference in yields between long- and short-term bonds, look at a graph of the yield curve. The vertical axis is generally the yield, while the horizontal axis represents a bond's holding period. For example, a yield curve might show bonds that range from three months to 30 years. In normal environments, the curve moves up and to the right because longer-term bonds often have higher rates. However, there may be areas of the curve that are more or less steep.

In some cases, the yield curve may be flat or inverted. With a flat yield curve, long-term bonds pay roughly the same as short-term bonds. When the curve is inverted, longer-term bonds pay less than short-term bonds.

A yield curve can show you what bond investors expect from the economy and interest rates. For example, an inverted curve suggests that investors expect interest rates to be lower in the future than they are now. That might be the case when short-term interest rates rise sharply, such as when investors expect high inflation. The assumption might be that rates will be high for the next few years, and then fall after the economy cools off.

The curve doesn't predict the future—but it can tell you what investors currently believe.

Risks for bond investors

Investors often think of bonds as instruments that can help to stabilize portfolios during volatile times. That's sometimes true—but bonds are not risk-free investments. Some of the biggest potential obstacles are highlighted below.

Inflation risk

How does inflation affect bonds? Bonds are generally fixed-income investments. They pay a stated yield that is set when the bond is issued, and that rate typically doesn't change. However, if inflation causes expenses to rise rapidly, the income from bonds may not keep up. As a result, investors lose purchasing power over time. For example, if a bond pays 4% while inflation is running at 7% per year, you effectively lose 3% of the financial value you previously had—even if the dollar value of your holdings continues to increase.

Accordingly, some bonds are designed to mitigate inflation. They might feature periodic adjustments that help reduce inflation's impact, but there are always trade-offs involved.

Interest rate risk

When interest rates change, bond prices typically move in the opposite direction. Consider a situation where inflation is running high and the Federal Reserve wants to tighten the money supply. When that happens, it becomes harder for banks to borrow and lend money. In response, interest rates might rise.

Back to the example used above. Say you purchased a bond for $1,000 that pays 4%, but you need cash now, and you'd like to sell the bond to somebody else. If rates rise and bonds from similar issuers pay 5%, your bond will likely be less attractive—investors can get a higher yield for the same level of risk if they just buy a new bond. So, to compensate, you might need to accept $800 for your bond (resulting in a 5% yield that investors will find attractive). Unfortunately, that's a $200 loss, and you might be selling numerous bonds at that reduced price.

In most cases, the damage is greater for long-term bonds when rates rise. On the other hand, short-term bonds mature relatively soon, allowing investors to reinvest into higher-yielding bonds.

Default risk

Because a bond is a debt instrument, the issuer promises to pay interest on the amount you lend, and they promise to repay the loan when the bond matures. However, sometimes issuers default on their obligations. For example, they might go bankrupt and fail to pay anything after that point. Some bonds are safer than others; U.S. government bonds are generally considered safe from default risk, but anything is possible.

Higher-risk bonds, such as those from companies that lack financial strength, tend to pay higher rates than you get from U.S. government bonds. That's because companies in distress need to pay a relatively high yield to compensate for the extra risk investors are taking.

Other risks

Bond investors face a variety of other risks in addition to those listed here. Some of those issues relate to the mechanics of trading and maintaining bond holdings and are less directly related to inflation and credit risks. A financial advisor can help you understand the intricacies of these risks.

The lowdown on bonds & inflation

Bonds can play an essential role in your portfolio, but it's critical to understand how they act when influenced by inflation. Along with default risk, the effects of inflation may be one of the biggest threats bondholders face. You risk losing purchasing power as fixed-income investments fail to keep up with rising prices, and the market value of bonds may fall if interest rates rise.

That said, bonds can provide valuable income in a well-diversified portfolio—even with inflation looming.2 The question becomes what types of bonds to use and how much exposure (if any) is right for your portfolio. That answer will look different for everybody, which is why it's important to tailor an investment strategy to your goals.

To get help with navigating inflation and all the other uncertainties in life, consider reaching out to a local Thrivent financial advisor. These experienced professionals can explore your possibilities with you and share appropriate solutions for your individual situation.

1 Hypothetical examples are for illustrative purposes. May not be representative of actual results.

2 While diversification can help reduce market risk, it does not eliminate it. Diversification does not assure a profit or protect against loss in a declining market.